(Bloomberg) -- Investors have a fickle relationship with credit mutual funds lately, pouring cash in one year and yanking it out the next.
As a result, the world’s biggest mutual-fund firms are preparing for when sentiment sours for a prolonged period. They’re increasing the amount of cash in their portfolio and boosting their holdings of corporate-bond exchange-traded fund shares -- which trade like stocks instead of the antiquated, telephone-based system of buying and selling debt.
Managers are using exchange-traded shares that track pools of less-traded debt “as a means to smooth out their exposure during redemption periods,” Colby Jenkins, a Tabb Group analyst, wrote in a March 2 report.
Up to 10% of some corporate-debt funds’ holdings now consist of ETFs, a proportion that’s been rising for the past two years, according to Tabb Group research. ETFs are also being used as an easy way to invest in bonds after receiving large inflows, according to Jenkins.
The potential for big outflows from U.S. bonds is all the scarier now because trading volumes have failed to keep pace with the 21% growth in outstanding debt since 2007. While taxable bond funds have received $932 billion of deposits since the end of 2007, Wall Street’s biggest banks have cut holdings of the debt previously used to facilitate trading.
“There has, indeed, been a meaningful deterioration in the ability to trade corporate bonds from the pre- to post-crisis period,” Barclays analysts led by Jeffrey Meli and Bradley Rogoff wrote in a Feb. 27 report. “This has resulted in increased investor reliance on products such as ETFs” to manage liquidity.
ETFs now represent about 2.5% of the investment- grade corporate market from almost nothing before the 2008 crisis, and they account for almost 3% of high-yield bonds outstanding, Barclays research shows.
Of course, there are some questions about how well ETFs will work as a liquidity tool in a downturn, too. There’s the potential for ETF shares to move away from the underlying market in a time of stress, forcing fire sales of assets that don’t trade as often.
The fragile new equilibrium stems from “liquidity mismatches between the assets themselves and the instruments being used to manage daily liquidity needs,” Barclays analysts wrote. Well-intentioned regulations and “a growing demand for liquidity may have led to increased instability and fire-sale risk in corporate debt markets.”
While the U.S. bond market looks downright attractive next to the almost $2 trillion of European sovereign debt carrying negative yields right now, it’s still prone to losses. Bond funds increased their proportion of cash-like holdings to 7.1% at the end of December from about 3 percent in 2010, according to Investment Company Institute data.
In February, dollar-denominated bonds lost 1%, the worst monthly decline since June 2013, according to Bank of America Merrill Lynch index data. Benchmark yields have risen -- albeit not very much in the grand scheme of things -- as the Federal Reserve lays the groundwork to raise overnight borrowing costs as the U.S. economy shows signs of accelerating.
While fears of redemptions may be overblown, bond fund managers are hoping these precautions mean they won’t have to blink if investors head for the exits all at once.