Speaking at a broker-dealer conference last week, I asked the audience if there were reasons to worry about the state of the U.S. stock market. As you might expect, the answer was almost unequivocally yes and the list of potential potholes for this market wound up being quite lengthy.

However, one of the things that keeps me up at night, so to speak, has nothing to do with the stock market. No, it is the bond market in general and the European bond market in particular that causes me angst.

You see, volatility in the bond market is on the rise – in a big way. For example, while most investors probably aren’t even aware the event occurred, there was a “flash crash” in the bond market back on October 15, 2014. As was the case with most of these “flash” events, the market recovered quickly and in effect, all’s well that ended well, right?

However, there two nagging questions here. First, since there has been no real explanation of the event, why did yields in the U.S. bond market suddenly dive and then recover on that day? And second, how is such an event even possible in what can be considered one of the most liquid markets on the planet?

Liquidity (or Lack Thereof) Is The Issue

Early last month, a NYT DealBook article talked about the growing concerns by both bankers and regulators relating to the increase in bond market volatility. In essence, the article suggested that a “surprise” in the bond market such as an unexpected rate hike or an external event would likely cause liquidity to dry up dramatically. And in case you’ve forgotten, it was the abject lack of buyers during the 2008 credit crisis that created much of the damage.

Part of the problem here has to do with the growing popularity of ETFs as the weapon of choice for many investors/traders. In fact, ETF assets now represent nearly 10% of the total bond fund assets out there. And the simple truth is that these vehicles do not have enough cash sitting around to meet redemptions if a serious downturn develops.

It is also worth noting that trading volumes in the corporate bond market have shrunk significantly in the last 5-10 years. According to Ned Davis Research, the average daily trading volume of corporate bonds was $238 billion at the end of 2007. But today that number is just $108 billion. This means that trading volume is down 55% from pre-crisis levels.

In addition, dealer positions in the corporate bond market have been slashed. Prior to the crisis, primary bond dealers held what was then a record $286 billion in bond positions. However, those positions are now down more than 90% and stand at just $23 billion. Yikes.

The Problem Is…

In other words, the liquidity in the bond market just isn’t what it used to be – not by a long shot. So, the question becomes, what happens to bond prices when/if fund managers are forced to reduce their positions? What happens to the daily liquidity with computers controlling the flow? And what will happen to all those bond fund investors if something bad actually happens in the bond market?

The short answer is, nothing good.

Long Live QE

Why aren’t people worried about this, you ask? At least part of the reason is that the global central banks of the world continue to pump liquidity into the markets. Remember, the Bank of Japan and the European Central Bank are running their printing presses 24/7 these days. And as long as that flow of fresh cash continues then liquidity isn’t likely to be much of a problem.

However, at some point, the world’s central bankers will run out of reasons to print money. And it is also conceivable that at some point the major economies of the world won’t need the “life support” the central bankers have been providing. What happens to bond prices then?

Now let’s take this one step farther. Remember, after two brutal bear markets in stocks between 2000 and 2008, the investing public moved a big slug of their assets from the insanity of the stock market into the relative safety of bond funds. But again, what happens to the value of those bond funds when rates rise? What will investors do when they see their so-called “safe” holdings start to dive – perhaps in a flash?

Yep, that’s right, those investors are going to sell some of those bond funds. And in turn, the bond fund managers are going to have to sell holdings. But the question could easily become: Sell? Sell to whom?

Yep, this is definitely one of the things that keeps me up at night and one of the primary reasons that I believe in an active, risk-managed approach to the markets.