Top U.S. money managers raised concerns at an informal discussion with New York Federal Reserve President William Dudley last month about the large inflow of dollars from mom-and-pop investors into fixed-income funds the past few years.
Recently released minutes from the April 12 meeting of the Investor Advisory Committee on Financial Markets, which includes hedge fund manager David Tepper of Appaloosa Management LP and Rick Rieder of BlackRock Inc, reveal money managers expressed concern about how a policy change could send longer-term rates higher and hurt retail investors in bond funds.
The minutes from the group's meeting with Dudley and some of his senior managers said the managers discussed how the Fed's efforts to keep interest rates low in order to spark the economy had created a "larger footprint of retail accounts in credit markets" and "fixed income instruments."
But the group, looking at the prospect of rates rising soon, told Dudley and his team there are "risks associated with the potential reaction of retail investors to a sharp rise in rates," the minutes said.
The release of the minutes, which were posted recently on the New York Fed's website, comes at a time when many money managers are predicting an end to the decades-long bull market in bonds and predicting that the Fed will soon begin to pull back on its aggressive "easy money" policies.
So far this year, U.S.-based taxable bond mutual funds and exchange-traded bond funds have attracted $129 billion in net new inflows, while money market funds have suffered outflows of $123.7 billion for the same period, according to Lipper data.
The Fed's massive bond-buying program - $85 billion a month of U.S. Treasury debt and residential mortgage bonds - has driven bond prices higher and pinned their yields, which move in the opposite direction, near record lows.
Twelve of the 15 investor members were in attendance at last month's meeting. James Chanos, founder and president of Kynikos Associates, and Mohamed El-Erian, chief executive officer and co-chief investment officer at PIMCO, were not at last month's meeting, according to the minutes.
Federal Reserve Bank of New York attendees included Dudley as chair of the meeting, as well as the head of market operations, Simon Potter, First Vice President Christine Cumming, and the director of research at the Fed bank, Jamie McAndrews.
The minutes from the Investor Advisory Committee's latest meeting went on to say: "Uncertainty was expressed as to the potential market-functioning impacts of large outflows from corporate credit-related mutual funds and ETFs, especially as retail holdings of corporate bonds have increased relative to market volumes and broker-dealer balances have decreased."
The quarterly meetings serve as a forum for informal discussions on financial, economic and public policy issues. The meetings help inform the New York Fed's president and senior management. The committee's membership is comprised of leaders in the investment community. The panel is solely an advisory group with no formal policymaking responsibilities.
EVEN JUNK-BOND YIELDS DROOP
At April's discussion, investors discussed the current state of investor positioning for a potential rise in interest rates and raised red flags that the business model of real estate investment trusts, or REITs, that invest in government-guaranteed mortgage-backed securities "was viewed as vulnerable to any sharp rise in rates, given relatively high leverage and perceived duration mismatch between assets and liabilities."
Some Fed policymakers have increasingly questioned the bond purchases, with some saying it is creating investment bubbles in certain markets, like the one for REITs and junk bonds.
The U.S. junk bond yield-to-worst, or worst-case scenario yield, recently dropped below 5 percent for first time, an indication that investors are not getting much return for the risk they are taking.
A bond's yield drops as its price rises, a sign of increased demand. Investors in their quest for yield have been buying riskier debt.
Regional banks were also cited as having some sensitivity to losses in the case of a sharp rise in rates, particularly as banks have added higher-yielding assets to their portfolios in the low rate environment.
Last week, Federal Reserve Chairman Ben Bernanke began what could be a months-long campaign of jawboning investors to stop dangerously chasing yield - an indication that it's not just money managers worrying about a rise in rates.
"In light of the current low interest-rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals," Bernanke said.
(Editing by Jan Paschal)