Even if the recent volatility in the financial markets starts to calm down, the bond market could experience a second stage of selling as mutual fund investors start receiving their quarter-end statements and react with even more selling.
“What is scary here is the forces of mutual fund investors' seeing their net asset values drop, and they are going to start dropping significantly,” said Dan Toboja, senior vice president of fixed income at Ziegler Capital Markets.
The stock and bond market sell-offs that began in earnest last week after Federal Reserve Chairman Ben S. Bernanke made clear that quantitative easing can't go on indefinitely have driven up the yield on the 10-year Treasury bond by 19% to 2.6%.
Although most market watchers saw the sell-offs as an inevitable reaction to the realization that the Fed's $85 billion monthly stimulus program eventually will end, Mr. Toboja thinks that the timing of the market volatility will add some salt to the wounds.
“Any retail investor with a bond fund will see their [June 30] quarter-end statement, and a lot of them will want to sell what could look like lousy-performing funds,” he said. “When they start pulling more money out, the managers have to sell more, and that's how these things get legs.”
Even though Mr. Toboja considers the market sell-off an overreaction to the Fed statement and signs of an economic slowdown in China, he said that most portfolio managers will be holding what cash they have to prepare for a second wave of selling by retail investors.
“It's a buying opportunity, but right now, everybody wants cash on hand in case they face more redemptions, so nobody is stepping up,” he said. “I'm looking for some stability and waiting for the smoke to clear, and I won't do anything until we can see some trades showing that there are buyers who want to put some cash to work.”
The domino effect of such a defensive strategy ultimately drains liquidity from the markets, particularly in the higher-yielding bonds, which drives the price of those bonds lower.
Investors should be looking at the recent pullback as an “enormous opportunity” and a “second chance” to get into the market, said Doug Cote, chief market strategist at ING U.S. Investment Management.
“Investors have been waiting for the big pullback, and this is that buying opportunity,” he said. “I think the sell-off has been overdone based on fundamentals, especially in the bond and Treasury markets.”
Even as the Dow Jones Industrial Average fell by more than 670 points, or 4.4%, following last week's Fed statement, market volatility has been relatively tame, Mr. Cote said.
The volatility index, now at about 20, compares with a much more ominous level of 45 after the U.S. credit downgrade in 2011.
“The market's reaction is a bit overdone, and this is a buying opportunity to get into both bonds and stocks at a good price,” Mr. Cote said. “If you can't be a buyer in this market when the [Chicago Board Options Exchange Market Volatility Index] is at 20, you've got no chance.”