Asset allocators have warned pitfalls as a result of quantitative tightening (QT) are lurking in bond markets, which have the potential to cause a "bond catastrophe" forcing investors to reduce their credit holdings.
Cautioning investors, Man GLG's Craig Veysey, lead fund manager of the group's Strategic Bond fund, said QT could see "large swathes" of BBB-rated bonds tumble into the high yield index, while chief strategist at 7IM Terence Moll, said the bond market "masks a lot of danger".
Furthermore, Veysey explained QT will amplifiy volatility, worsen fundamentals and trigger credit downgrades. As such, BBB-rated corporate bonds could lose their investment grade status.
He pointed out the percentage of triple B-rated bonds has "exploded" since 2008 as companies have geared up their balance sheets with a view to buying back stock.
Indeed, BBBs have gone from under 20% of the market in 2003 to over 50% today, according to TwentyFour Asset Management.
However, Veysey said many of these bonds, in particular those issued by cyclical companies, could see capital losses if they are downgraded to high yield.
He said: "The suppression of volatility we have seen in recent years due to quantitative easing is reversing direction with quantitative tapering likely to amplify volatility. At the same time, the economic cycle is not as constructive as it was, with leading indicators weakening in many parts of the world.
"We are very, very cautious of those cyclical BBB-issuers that lack the flexibility to reduce the size of their balance sheet or increase their cashflow. We think a large number of these could quickly find themselves in the high yield index."
Veysey, who joined Man GLG from Sanlam with portfolio manager Francois Kotze at the end of 2018, is instead eyeing up defensive opportunities, namely special situations companies looking to deleverage and improve their credit quality rather than appeasing shareholders, such as Tesco and US department store chain Macy's.
Meanwhile, 7IM's Moll said the chance of a bond catastrophe remains "worryingly high" with the investment team reducing bond holdings in recent years.
Moll said cautious investors, who typically have higher allocations to bonds, are particularly at risk of rising interest rates decimating their capital.
"The maths is simple and inescapable - a 1% rise in the yield of a 10-year bond results in a (roughly) 10% loss of capital," Moll said.
He added that although expectations for four rate hikes from the Federal Reserve this year have been reduced following the bout of volatility and a more dovish tone in January's FOMC minutes, rates are still on a rising path, with the current level still much lower than the long-term average of 5%.