The deteriorating state of bond market liquidity has been a dominant concern among bond investors in 2015.
Given how expensive it has become to enter and exit bond positions, especially in the cash market, there is a lot of investor angst over the ability of bond markets to handle a period of severe selling that could unfold if the Fed does indeed begin to lift rates in September. The greatest fear of both investors and regulators is that a “fire sale” of debt could occur if outflows from bond funds were to accelerate, forcing portfolio managers to sell bonds to raise cash to meet redemptions. This scenario could create a cascading wave of selling pressure on bond prices, most notably in heavily-owned corporate bonds.
We continue to believe that the risk of Fed liftoff is the biggest threat to credit markets, as there are already signs that the correlation between credit spreads and Treasury yields is turning positive, as has occurred during every run-up to Fed liftoff over the past 25 years. Nonetheless, the risk of a “fire sale” of bonds in corporate debt markets is overstated, in our view. Please see the next Insight, (Part II) Bond Market Liquidity Will Not Get Any Better.