Retirees, Beware Hidden Danger Lurking in Bond Funds

Regulators and money managers are raising alarms about a growing threat to bond funds and their investors. The concerns revolve around "liquidity" -- the ability to buy or sell a security at a decent price within a reasonable period of time.

As a result of new regulations enacted since the financial crisis, broker-dealers -- the bond market's middlemen -- have sharply curtailed their trading activities. At the same time, corporate bond issuance has surged as companies seek to take advantage of ultra-low interest rates. So in a larger market with fewer middlemen facilitating trades, it's getting tougher for mutual funds to buy and sell bonds.

That can become a real problem if rising interest rates or other market events prompt investors to stampede out of bond funds. A fund struggling to quickly sell bonds to meet investor redemptions may have to dump holdings at fire-sale prices -- triggering a vicious cycle of falling bond prices and investor panic.

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That means it's increasingly important for investors to understand what their bond funds hold -- and how difficult it can be to trade those holdings.

The Securities and Exchange Commission in September proposed new rules that would require funds to maintain a minimum level of highly liquid assets. The proposed rules would also require funds to disclose the percentage of their total holdings that can be converted to cash within three days.

Low liquidity is not a new issue in the bond market. Many bond issues are small and rarely change hands, and riskier, lower-quality bonds have always been tougher to trade. But liquidity problems have grown more acute in recent years. As investment-grade corporate bond issuance soared in recent years, corporate bond turnover -- a measure of trading volume relative to the size of the market -- has declined steadily, according to a T. Rowe Price report. And while "the high yield market has always been illiquid, in the investment-grade and Treasury market, it's new to have less liquidity," says Elaine Stokes, a fixed-income portfolio manager at Loomis Sayles.

To adapt to a lower-liquidity market, some funds have set up lines of credit they can tap if shareholder redemptions surge. Others are holding more cash and highly liquid high-quality bonds. "On the worst days, when bonds are quoted down the most, not a lot is trading," Stokes says. "But as things start to recover, that's when people start to let go of the bonds."

Assessing Your Exposure

As a bond-fund investor, you probably can't avoid liquidity risk altogether -- at least, not if you want to get a decent yield. "There is a trade-off," says Sarah Bush, director of manager research for fixed-income strategies at Morningstar. "You get paid for taking liquidity risk."

You can, however, get some sense of your funds' liquidity risks by delving into the portfolio holdings. Review each fund's quarterly reports, or go to Morningstar.com to stay up-to-date on current holdings. Cash, Treasuries and high-quality agency mortgages are generally the most liquid holdings, Bush says.

Check out the fund's cash allocation. A large cash cushion offers some reassurance that the fund can easily meet large shareholder redemptions. Yet some funds have virtually no cash. In a recent study, the SEC found that at least 10% of municipal-bond funds hold no cash or have a net negative cash position.

Look at how much the fund has allocated to lower-quality bonds. A BB-rated bond with a lot of issuance may be much easier to trade than a junkier CCC-rated bond. Be wary if the fund's yield is well above its category average, "because less-liquid bonds tend to pay more," Bush says.

Finally, check how the fund has performed in past periods of market stress. Look to 2008 for its financial-crisis performance, as well as May through August 2013, when the market tumbled as the Federal Reserve wound down its bond-buying program. If the fund suffered more than its peers, it may have bigger troubles in any future liquidity crunch.