July 7, 2017 / 7:14 PM / a month ago

Federal Reserve sees possible risks in U.S. bond market

July 7 (Reuters) - The Federal Reserve saw possible risks in the U.S. bond market that include a jump in long-term Treasury yields and money market funds selling out of government and agency debt, according to a central bank report released on Friday.

These possible threats to the bond market seem remote though as the Fed assessed that vulnerabilities in the financial system "remain moderate on balance" in its semiannual report on Congress.

U.S. Treasury debt term premiums, or what investors demand in yield to hold a longer-term bond after adjusting for inflation, have been running at historic lows due to strong investor demand and to the Fed's ongoing purchases of U.S. government debt.

If term premiums were to revert to higher levels, there could be repercussion beyond the Treasury market, the Fed said.

"A sudden rise in term premiums to more normal levels poses a downside risk to long-maturity Treasury prices, which could in turn affect the prices of other assets," it said.

A pickup in term premiums raises the appeal of long-dated Treasury debt rather owning stocks and other riskier assets.

On Friday, the yield on 10-year Treasury Inflation Protected Securities (TIPS), a gauge of longer-term U.S. term premium, was 0.63 percent. This was above the minus 0.84 percent in December 2012 but well below the 2.65 percent seen prior to the onset of the 2007-09 global financial crisis.

The central bank also said it was keeping an eye on the $2.6 trillion money market fund sector, which fully implemented a reform designed by the Securities and Exchange Commission in October 2016.

The tighter SEC regulations are aimed at averting "run risk" seen when the share price of the Reserve Primary Fund fell below $1 or "broke the buck" following the collapse of investment bank Lehman Brothers in 2008. Investors rushed to pull their money from the fund due to its heavy holdings of Lehman's debt.

In 2016, money funds shifted $1.2 trillion of assets into Treasury bills and short-term debt issued by mortgage finance agencies as many of them converted into "government-only" funds from prime funds that can hold riskier securities.

This move into safer securities has reduced the run risk for money funds, but if a reverse back into "more opaque and fragile alternative vehicles" were to occur, run risk could go up again, the Fed said.

"Thus, continued monitoring of this sector is important." it said in the report. (Reporting by Richard Leong)

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