When rates start to rise what will happen to the bond mutual funds? Could the lack of liquidity in bond markets and a market structure of requiring a broker to execute trades lead to a liquidity crisis?
There is a difference between owning individual bonds and owning a bond mutual fund.
When it comes time to sell, it can
be hard to find a buyer, and vice versa. PIMCOs
chief investment officer for U.S. core strategies, Scott
Mather, has compared the bond market to that for real estate. Few people list their houses on a website and expect to find a buyer. Instead, they pay an agent, who may
know a young couple interested in a fixer-upper next to the
railroad tracks. Both bonds and houses are far from
homogeneous. Real estate brokers have maintained their grip on
their market, despite consumers buying everything from
groceries to puppies online. “You can’t force every
house to be the same or force every issuer to issue the same
bond,” says Mather. Since the financial crisis, though,
players in the bond market have become more receptive to
technology and new solutions. They’ve had to as banks have
been regulated out of playing their traditional role as market
makers and, in a pinch, providers of liquidity.
Source: On Liquidity Anxieties and a New Bond Market
An interesting article by Jason Zweig in the Wall Street Journal brought up an important concept that most investors pay little attention to, the current yields on the bonds in their portfolios, and which yield should be considered when deciding what bonds to purchase.
There are several different yield calculations for different kinds of bonds. For example, calculating the yield on a callable bond is difficult because the date at which the bond might be called (the coupon payments go away at that point) is unknown. There is the yield to maturity, which is the yield from holding the bond to maturity (assuming that you can reinvest all the coupon payments at the same rate as the bond’s current yield.) And there is also the current yield, which is the one a bond buyer should use when comparing different bonds to purchase.
The current yield is defined as the ratio of the coupon interest to the current market price and is what you can expect to receive by buying that bond today at the currently quoted price.
Current Yield = Annual Cash Flow / Current Bond Price
However, if the bond were to be sold at a capital gain or loss, or if the bond is called (bought back before maturity by the issuer) then the current yield would not be realized by the holder.
In today’s low rate environment I would favor evaluating bonds based on their current yield, using the yield to maturity measure may not be an accurate representation of the return the holder will receive given that it will be difficult to reinvest the cash flow from the annual coupon at the same rate.
Source: How Muni Bonds ‘Yield’ 4% in a 2% World