Thursday, Jun. 26, 2014

Nobody has been more critical of the regulators (SEC, FINRA) than I have, so when it seems they are for once out ahead of a problem I must give them their due.There is a looming problem coming in the credit markets. Bond funds have become huge as more investors are looking for some kind of interest based return. Meanwhile through a combination of regulatory oversight and business decisions Wall Street has become smaller. This is not a problem as long as the market is quiet and interest rates stay in a narrow band. The problem will arise when interest rates go up and bond funds are facing redemptions and need to sell bonds. Wall Street's main function is to provide liquidity between buyers and sellers, so when a fund needs to sell bonds the street will usually give the account a bid and later resell the bonds to another investor. Since 2009 the money flow has been into bond funds and investment banks have been happy to sell bonds to these investors. At the same time the investment banks have been cutting back on their trading positions and are no longer willing or able to provide the level of liquidity should the funds need to sell bonds in a hurry. There is nothing magic about the bond fund industry, they pretty much buy at the same time and sell at the same time, totally dependent on the appetite of the public for their product. Should interest rates go up (and some day they will) and should the bond fund industry need to sell bonds to meet redemptions (and they will) the market could easily be overwhelmed. This will be a problem. A sneak peek at this phenomenon was evident last summer (2013) during the "taper tantrum". Forewarned is forearmed, caveat emptor.