The Fed and the Exodus From Bond ETFs

NEW YORK ( ETF Expert) -- The familiar pattern of May-June gloom for stocks only led to a 5% selloff in 2013. Bonds, however, witnessed a repricing that many had not seen since 1994. Intermediate-term Treasuries lost 7% to 8%. Munis fell more than 10%. Meanwhile, investors trampled emerging market bonds for 12% to14%.

Why did people redeem assets from bond funds so quickly? Why did the pace of those redemptions create liquidity issues for the fixed-income marketplace?

In brief, the Federal Reserve had hinted that it might slow down the rate of its quantitative easing experiment of buying bonds to push rates lower. Consequently, the 10-year yield nearly doubles from 1.6% to 3% in an extremely short time frame.

Many are now suggesting that a future crash in bond funds is a near certainty. They maintain that when rates rise -- not if they rise -- bond mutual funds and bond ETFs will not be able to handle the selling due to a lack of liquidity in the underlying assets.

Indeed, during the height of this year's chaos, municipal bond ETFs like PowerShares National Muni ( PZA) and iShares S&P National Muni ( MUB) were trading at net asset value discounts of 300 basis points for at least a week. In the world of exchange-traded investing, premiums and discounts are supposed to be negligible.

Courtesy of StockCharts.com

It is probably accurate to say that an erratic jump in fixed-income yields would cause trouble for bond funds yet again. As investors liquidate fixed-income fund positions, the huge number of bonds hitting the marketplace would likely overwhelm bond dealers and the liquidity of the bonds themselves.

On the other hand, the Federal Reserve walked back "taper talk" in late June as it became clear that bond selling had been getting away from their control (and manipulation). Volatility notwithstanding, muni price depreciation has abated and muni tax-free income has been valuable ever since.

Courtesy of StockCharts.com

It follows that the central bank of the United States is aware of its power, not only to cause panic but also to quell panic. In fact, in a world where nearly all of the major banks are fostering exceptionally low interest rates -- in a global environment where the low-rate trend is likely to push forward into 2016, 2017, and 2018 -- a bond fund crash is unlikely. Rising interest rates? Sure. An overnight spike where rates nearly double (the way they did from 1.6% to 3%)? Not probable.

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