How high-yield bonds became a source of worry for stocks

AP News
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Posted: Nov 12, 2015 4:19 PM

NEW YORK (AP) — How upended have the rules of investing become? How's this: Investors are talking about whether problems in the market for corporate bonds may spill over into stocks and drag down their prices.

That question could have caused smirks years ago. Stocks have historically been the riskier investment, prone to big swings, while bonds just chugged along. But analysts say the high-yield corporate bond market has become increasingly fragile. Conditions may be lining up where investors one day find no buyers for bonds when they look to sell, or at least none at a palatable price.

That's led to speculation about a scenario where panic in the high-yield bond market bleeds into stocks through a group of mutual funds known as "hybrid" funds. They own a mix of stocks and bonds and control more than $1 trillion as a group.

To be sure, analysts say the likelihood of such a scenario is remote. A lot of events would need to happen in succession. And managers of hybrid funds say that even if a sell-off did hit the high-yield bond market, it wouldn't have much effect on the stock market because of the types of stocks they own.

The fact that investors are discussing the possibility shows how much worries have risen about the market's fragility. Even if the threat is unlikely, it's "one that in our opinion cannot be ignored," strategists at the investment bank UBS wrote in a recent report.

THE ROOT OF THE CONCERN

Like their name suggests, high-yield bonds pay more interest than other bonds. That's because they carry higher risk. They're issued by companies deemed more likely to default, at least in the eyes of credit-rating agencies.

The worry is that many novice investors have poured into the high-yield market. These "tourists" were desperate for higher interest rates, given the low yields available in savings accounts and high-quality bonds, but may not appreciate the additional risk. If these investors panic and pour out of high-yield bonds at the same time, prices would plummet.

What's more, investment managers say it's already getting more difficult to find buyers for some bonds. It's a concept called liquidity, and several reasons may be behind its decline. Among them: Regulations are forcing Wall Street banks to be more careful with their balance sheets, and they're less willing to be buyers of bonds.

TRANSMISSION MECHANISM

When investors request their money back from a mutual fund, managers have to give them cash. That means big problems for managers facing a wave of redemptions when they're stuck in investments they'll have trouble selling.

Hybrid mutual funds have a shade below 20 percent of their assets in corporate bonds. If they can't turn those into cash, they'll sell whatever they can. That could mean the stocks that they hold, which are among the most liquid investments in the world, Barclays strategists wrote in a recent report. Roughly 60 percent of hybrid funds' assets are in stocks.

Ironically, high-quality stocks could be the most affected by a sell-off in low-quality bonds.

Many hybrid funds tend to own similar kinds of stocks: big, steady dividend payers. So this handful of stocks would feel the brunt of any forced selling by hybrid funds. Analysts point to such companies as JPMorgan Chase and Verizon Communications.

HOW LIKELY IS THIS TO HAPPEN?

Not very. The high-yield bond market has already had a couple scares that have driven some investors away, and it has so far avoided an outright run on mutual funds.

Many hybrid fund managers may end up selling their stocks to raise cash when troubles hit the high-yield bond market, says Margie Patel. She runs mutual funds that own a mix of stocks and bonds, including the Wells Fargo Advantage Diversified Capital Builder fund.

That may not hurt stocks all that much, because the ones hybrid funds own tend to be among the largest in the world. Microsoft, for example, is a popular investment for hybrid mutual funds. It's also the second-biggest stock in the S&P 500 index and worth about $430 billion.

"I don't think the amount of equities that would be moved would be enough to move the needle," Patel says. "If a fund sells some Microsoft, it's not going to change the price that much."