Written by: Michael Joyce, CFA, CFP

The past six months have seen very strange events in the bond market.  Bid prices on seasoned bonds, particularly those in the energy and natural resources sector, have plummeted due to indiscriminate selling and a lack of buyers, despite the fact that many bond issuers remain fundamentally solid.  Then over the past few weeks, fear stemming from a lack of liquidity caused the high yield bond market to drop.

The lack of liquidity can be attributed to unintended consequences of regulation.  The so-called Volcker Rule provision of the Dodd-Frank Act has reduced the market-making activities of many institutions.  This means that natural buyers such as banks cannot buy bonds even when prices are declining.  U.S. primary dealers’ holdings of corporate debt securities have declined by more than 85% since peaking in October 2007.  Unfortunately, concern over the lack of liquidity has caused other market participants (like ETFs) to flee bonds in panic.  Bond default rates are still near historic lows, near 2%.  However, bid prices on bonds have dropped further and faster than when default rates were in the 10% to 12% range in 2008-2009 and the early 1990s.

There is no doubt that the large drop in oil and commodities prices have spooked bond investors in the energy and natural resource sectors.  I certainly didn’t foresee a 65% drop in oil prices over the past 18 months, including 40% just since June 30.  Make no mistake; there will be plenty of marginal energy producers that will go bankrupt absent a reversal in energy prices.  Despite the problems in this sector, bonds in companies with good liquidity should fare better.  Since we almost always hold bonds to maturity, we can withstand the volatility in bonds’ bid prices because bonds, unlike equities have a built-in catalyst.  That catalyst is a call or maturity price at a preset date, and we would generally expect to see the price of bonds rise to these call or maturity prices over the coming years as those dates approach.

It is disappointing and unsettling to see the bid prices of bonds fall prior to maturity.  These drops have been exacerbated by the unintended consequences of regulation creating perhaps the strangest environment in bonds that I have seen in my 33 years in the finance industry.  We remain focused on the yield to maturity on the short-term bonds that we hold and remain confident that bonds with sufficient liquidity will be able to withstand the short-term challenges and pay us back at maturity.

This crazy environment has also created opportunity not unlike the early 1990s, early 2000s and 2008-2009 (albeit with much lower default rates as noted above).  Fear-driven selling will continue to impact credit spreads which means higher yields to maturity.  However, we still need to be selective as this strange environment in Bondland could last for a while into 2016.