Retail Investor Nightmare: The Bond Fund Rout

Wolf Richter's picture

Wolf Richter

The bond selloff didn’t surprise anyone. Investors knew that it would happen, would have to happen. Gurus of all stripes had predicted for years that it would happen, that the ridiculously low yields weren’t sustainable, that the Fed would eventually have to back off – only to watch with a mix of helpless frustration and ironic bemusement as the Fed or some other central bank opened the spigot even wider.

Meanwhile, investors decided to brush off the razzmatazz and just hang in there until it would happen, then get out in the nick of time. And they rode up the most gigantic bond bubble in history. But real cracks appeared in the Treasury market last fall when yields rose despite the Fed’s announcement of QE infinity designed to repress yields.

So, on April 30, it became official. In light of sky-high corporate bond prices and record low yields, billionaire Wilbur Ross of WL Ross & Co. warned during a panel discussion of the long-term issues in bond la-la land. This – whatever was coming down the pike – wouldn’t be just a brief dip that you could buy. A mountain of debt had been issued in recent years at artificially low rates, thanks to the Fed’s machinations. It would have to be refinanced in a few years at much higher rates. “There’s a tremendous amount of interest-rate refinancing risk being built up,” he said. “We’re just building a bigger and bigger time bomb.”

Others chimed in. Joshua Harris, co-founder and chief investment officer of private-equity powerhouse Apollo Global Management, offered this tidbit of immortal wisdom to the still euphoric bondholders: “run – do not walk!”

And they did. All at the same time. It stopped the crazy feeding frenzy for yield. It turned the junk-bond bubble into a rout overnight. That “time bomb” would hit them the hardest. There’d be defaults. Value would just vanish. These risks are worth taking, if yields are high enough. But they weren’t. As the average yield on junk bonds hit a record low of 5.24% on May 9, investors opened their eyes [my take: The Day The Big Fat Junk-Bond Bubble Blew Up]. By June 26, it had jumped to 7.02%. And it’s just the beginning. The chart shows this vicious 6-week spike:

Even some of the least risky and most liquid paper out there, Treasuries, started diving in early May. Last week, the 10-year note experienced its worst selloff since June 2009 – the depth of the Financial Crisis! On Monday, yields hit 2.66% – up from 1.66% on May 2, and more than double the August low of 1.3%! Now they’ve settled a bit, at 2.58%. Investors are contemplating losses of over 10% since early May – in what is considered one of the most conservative investments around.

Those who own actual bonds, and don’t sell them, will be able to ride out the storm – assuming the issuer doesn’t default – patiently collecting puny coupon payments and allowing inflation to eat into their investment. But most retail investors, when they buy bonds, buy bond funds. And there, the massacre has been brutal: $48 billion have been yanked out of bond mutual funds so far in June.

Bond fund investors have a problem that holders of actual bonds don’t have: if your bond fund gets hit by massive waves of redemptions, you can’t ride out the storm without losses!

At first, a bond fund typically uses its cash cushion to deal with redemptions and then sell bonds gradually. Fund investors might not know the difference. But during big waves of redemptions, such as those recently, bond funds scramble to sell what they can sell into an increasingly illiquid market. So they’re selling Treasuries and their most liquid high-quality corporates – where losses are relatively small. The best stuff first.

Even in good times, corporate bonds can be fairly illiquid. There may be days and sometimes weeks or even months between trades of a particular issue. So marking illiquid bonds to market on a daily basis, when there is no discernible market, can be tricky.

But when bond prices drop, liquidity dries up further. The gap between what sellers want and what buyers are willing to pay becomes so wide that many bonds essentially stop trading – unless there is a forced sale! Hit with a wave of redemptions, a bond fund might have to sell less liquid bonds for whatever it can get for them – much less than the “market value” on its books. With each sale, the fund recognizes the loss. And as the fund dips deeper into its illiquid lower-quality bonds, particularly junk bonds, during the worst bouts of a selloff, losses accelerate. Investors get spooked and bail out. Hence, more redemptions. And more losses. It’s the reverse of the Fed-inspired feeding frenzy. The reverse of the wealth effect.

In the worst cases, such as the formerly $14-billion Schwab YieldPlus Select Fund, now defunct, it ends in a bloodbath. Even well-managed bond funds can have some ripples. Bond funds that realize losses while they’re forced to sell at the worst moment can’t recuperate those losses even if bonds – those that don’t default – rise again. Those gains go to whoever was on the other end of the transaction. And the buy-and-hold bond fund investor ends up holding the bag.

In an environment of rapidly rising interest rates, bonds with long maturities require nerves of steel and the willingness to sit on a crummy investment for years, or even decades. But bond funds can be outright treacherous – yet, in another display of Wall Street genius, it’s the conservative retail investor who gets lured into them.

It was the day when Private Equity firms – the smart money, the great beneficiaries of the Fed’s money-printing and bond-buying binge – announced their intentions to the rest of the world. The heavy hitters were there, and they let fly some pungent words. In short, they were “selling everything that’s not nailed down.” It was greeted with incredulity. Turns out, they weren’t kidding. They saw what was coming. Read.... The Smart Money Is Dumping “Everything That’s Not Nailed Down”

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Canucklehead's picture

I must admit, this battle of wits reminds me of the Battle of Eurymedon:

I wonder if we will be able to buy commemorative pottery much like the ancient greeks did back in the day...

q99x2's picture

I'm a student who would like someone to lend me more money so that I can get my PhD. My graduation date is May 28, I'll be 74 then and worth a lot to my grandchildren if I can help them buy a house with my student loans. I'm offering 4%.

g speed's picture

seems I read a while back that retail money was coming out of bond funds---may have been on ZH---this has been going on for a while now but with rates rising I can see a panic situation developing-- 

WhiteNight123129's picture

I had been yelling SHORT TREASURIES since last year as a hedge against my PM now SILVER bitchez!

SAT 800's picture

Excellent reporting. Well worth reading his blog.

Gringo Viejo's picture

Retail Investor? As Henry Gondorf said to the poker players in Doyle Lonigan's game:
"They wouldn't have let ya in here if you weren't a chump."

OpenThePodBayDoorHAL's picture

Greenspan started it with his Chicken Little policies after the Millenium bug & the Dot-Com bust. That flood of liquidity ensured there was so much excess capacity that headline inflation wouldn't happen. Clinton made sure there would be no wage inflation with NAFTA and GATT. Then The Wizard of Ben panicked when his owners had their existential scare in 2008. So here we are, assets are bid, jobs are gone, growth is gone, and the world's banks are walking zombies. At least we have the Great American War Machine to count on, Syria's lining up nicely for another trillion-dollar transfer from taxpayers to MIC shareholders. And the spying game is pretty juicy as well. Microsoft's largest customer by far: The US Army.

What a fucked situation. That can continue as planned for quite a while to come.

Scritchy's picture

You bet it can continue.  Since Ben's out of there in January, he's just covering his ass with taper talk so he can say later I told you so. His replacement is going to immediately double down on the stimulus/Keynsianism//douchebaggery. Exactly when it all blows up is anybody's guess.

Madcow's picture

yields are not rising because of "inflation" - but because risk premia must increase due to deflationa and collapsing income streams. 

as income flowing through the US economy is turned "off" - all financial instruments will evenutally fail - just as any car will evenually run out of fuel if it is not re-filled. 

the banks are flush with cash.  obviously, their interests are in waiting for assets to collapse to pennies on the dollar and then use that cash to buy up all the homes, farms, businesses, state parks, city monuments, private prisons, predator drone companies etc etc. in the land. 

then they will turn the income machine back "on"




SAT 800's picture

You're wrong. they're mindless. there's no plan. they just rip and run however they can.

Vegetius's picture



Interesting reading ZH the last few weeks, the situation is spinning further and further out of control. To say that Central Banks have control is the same as saying that a pilot of a burning shot up B 17 during WW2 had a lot of control. Bernanke can do two things grab a parachute bailout and pray the people he has just bombed will not lynch him or he can try and go for a controlled landing. Controlled landing during WW2 in fighters or bombers were deadly with the odds stack massively against survival, if you got the crate on the ground it was normal for the aircraft to start to burn with you in it.

With the news that Bernanke is leaving it should be obvious to the meanest intelligence that he is going to bail out and the only reason a pilot bails out?  The plane is in terminal territory, good to hear all the smart money is trying to leave, problem is where to go?

When this goes terminal it will not just be Bernanke that gets torn limb from limb

“Peoples do not judge in the same way as courts of law; they do not hand down sentences, they throw thunderbolts; they do not condemn kings, they drop them back into the void; and this justice is worth just as much as that of the courts.”

-          Maximilien de Robespierre

uncle_vito's picture

Folks, be realistic.   The economy sucks.   No way is the Fed going to stop QE and even if he does, higher interest rates cannot be supported.   There is not going to be a bond crash and no one but morons are in high yield bond anyway.   So relax already.

SAT 800's picture

The fact that higher interest rates cannot be supported is why the SWHTF; uncle vito. What you don't understand is that the FED is not in control of interest rates; the market is. Millions of people are in bond funds; all advertised as ":high yield". relax after you buy your Silver Bullion in a foreign jurisdiction; not before.

Toolshed's picture

"no one but morons are in high yield bond anyway"

Morons = 99.5% of mankind.

Sounds pretty serious now doesn't it? Time to panic.

alien-IQ's picture

Anything that cannot go on forever will cease.

Panafrican Funktron Robot's picture

Panic retail redemptions incoming July.  Bond funds aren't supposed to drop 10% in one month.  For retirees, this is blood money, and "return of capital" > "return on capital". 

Rainman's picture

Even at 7% junk bond yields are pitiful .... thank you, O Chairsatan.

disabledvet's picture

it's a market for DEBT not bonds...and i fail to see the "rout" (yet) you are alluding to. junk "bonds"? hahahaha. "well, that's why they call it junk." obviously the market rallying again "as the spread blows a mile wide" needs some explaining...but we'll leave that one alone for now. can equities and debt get killed together? yep. kinda scary when it happens too. but no...the retail investor isn't on the hook when that happens. that's INSTITUTIONAL money then. hence "institutions will respond." not an expert but seems to me that's exactly what happened with "taper." not saying the sell off isn't real of course. full scale rout? that's in precious metals "and all the institutions that bet on a one way trade." and yes...THAT is retail. not even i've done that...although it is pretty tempting right now after reading b.s. like this.

Western's picture

"but no...the retail investor isn't on the hook when that happens. that's INSTITUTIONAL money then."


uhm.. i believe that institutional money is tied to said retail's retirement fund.

uncle_vito's picture

BFD.   No news here.