No Place to Hide

The Dow Jones Industrial Average (DJIA) sold off 665 points yesterday.  It didn’t matter whether or not your portfolio was diversified. Stocks and bonds both fell last week. This is a market theme that I have warned about often over the last few years. Even a Treasury bond, which was once considered a low risk investment, offers little safety in this market.

Last week the S&P 500 dropped -3.88% and the iShares 20+ year Treasury Bond ETF (TLT) fell -3.04%. TLT is now down a staggering -5.54% since the start of the year. Even after the stock market loss last week, the S&P 500 is still up 3.22% for the year. Many Wall Street analysts speculated that the rise in interest rates caused the sell-off, while other analysts suggested that a few large companies released disappointing earnings reports. Another reason could be as simple as stocks became overvalued. The cause for the sharp drop in bonds and stocks is that both asset classes became less liquid as new buyers stepped aside.

Over the last decade, there have been many structural changes to the bond market. There are no longer as many bond dealers that hold bonds on their books. In the past, these dealers would buy and hold bonds, which would help to stabilize bond prices. The first question that you should ask yourself before making any new investment is what will be the liquidity when you go to sell.

There is one portfolio that I reviewed which can help serve as a good example of how a lack of liquid can turn a conservative investment into a speculative one. This portfolio consisted of all convertible bonds. There were many individual convertible bonds and a convertible mutual fund. The convertible mutual fund was sold to this investor as a very conservative investment. The marketing department of this investment company cooked up the idea that this mutual fund had better downside protection and offers an above average dividend. Nothing could be further from the truth. I could make a strong argument that a technology fund has lower risk than this convertible bond fund. Here is the chain of events that could cause this mutual fund to implode if bond markets become illiquid.

The first mutual fund holders that redeem this below-average mutual fund will sell at the highest bond prices. If selling continued, this fund would go into a death spiral as the portfolio manager is forced to sell it’s concentrated convertible holdings into an illiquid bond market. The other mutual fund owners left in this fund will begin to see the large losses as the portfolio sells its illiquid holdings. As even more fund owners realize that the fund is trailing all the other convertible bonds funds, they will begin to sell. I guarantee that this convertible bond fund portfolio manager will do their best to limit losses by first selling the most liquid bonds first. The remaining mutual fund owners will be stuck with all the illiquid holdings. This is how a mutual fund can end up last in its Morningstar category.

This is an extreme example of how liquidity can become a concern if interest rates begin to rise. Liquidity events have a way of moving from asset class to the next. In the coming months, one of the biggest risks to all assets will be how orderly the sell off is in the bond market, if interest rates continue to rise.

 

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