Fund managers are bulking up on cash, Treasurys in preparation for a less liquid bond market

Imagine the bond market as a crowded swimming pool, except it's one where the water level drops whenever someone tries to leave. By the time you attempt to get out, you're stuck at the bottom, unable to exit because the ladder is 10 feet above your head.

Now you know what the bond market is worried about. Bond fund managers are increasingly talking about the market's "liquidity," or how easy it is to buy and sell bonds. Concerns are rising that the day is approaching when everyone will rush for the exits at once and drain the market's liquidity, perhaps after the Federal Reserve begins raising interest rates.

"I think liquidity is misunderstood, and I think it is often taken for granted," says Matt Freund, chief investment officer of USAA mutual funds. "And the time to think about it is before you need it."

When liquidity is abundant, anyone who wants to sell a bond can easily find a buyer. But when liquidity dries up, buyers are scarce. At worst, none are available, or they're willing to buy only at fire-sale prices, and fewer bonds than you were hoping to sell.

For investors in mutual funds and exchange-traded funds, liquidity isn't much of a concern. They can pull their money from a bond fund at the end of every day -- or at any time during the trading day if they're in an ETF.

But the story is different for fund managers. They typically have some cash in their portfolios to return to shareholders who withdraw their money. But if there is a surge in withdrawals, managers could be forced to sell bonds to raise more cash. And if the market is full of others also looking to sell, bond prices plummet.

Depressed prices mean that investors who withdraw their cash from bond funds when liquidity is low may end up getting less than they anticipated.

Facing the prospect of diminished liquidity, some bond fund managers are building up their cash holdings. Not only does that give them a bigger cushion to pay out to redeeming shareholders, it also provides the power to be a buyer during a sell-off and take advantage of slashed prices.

Among other moves, some funds are also keeping more than they otherwise would in Treasurys, considered the easiest-to-trade bonds.

To be sure, there's a cost for such defensive moves: the lost income that the funds would have made by holding other types of bonds with higher yields.

Plus, even Treasurys have had bouts of volatility. In October, the yield on the 10-year note plunged by more than a quarter of a percent within minutes, something that could typically take days or weeks. The yield quickly recovered, but the steep, sudden move rattled investors.

Treasurys haven't had a shake-up like that since, but liquidity in other areas of the market is worsening.

"We're already beginning to see a market where it gets very difficult to sell securities in an efficient way," says Jeffery Elswick, director of fixed income at Frost Investment Advisors.

A year ago, when Elswick wanted to sell some bonds, he would routinely get back bids from at least 20 prospective buyers. "It's not uncommon now to get two, three or four," he says. "And one of those is so far out of the market that it's not even like bidding."

Given the liquidity concerns, Elswick has roughly a quarter of his Frost Total Return Bond fund in Treasurys. "All else equal, we would own 5 to 10 percent, max," he says.

Several reasons are behind the liquidity worries. Big Wall Street banks used to step in as buyers during past downturns but are now less willing. Fund managers say it's because of tighter regulations on banks' risk-taking.

Another worry is the impact of so many dollars in the bond market moving in the same direction. Bonds have been popular, and low interest rates have pushed investors to take more risk in search of extra yield. So money that used to be in a money-market account is now in a short-term bond fund, while money that used to be there is now in longer-term bond funds. The threat is that when interest rates rise, everyone will take a step back down the risk ladder. All at the same time.

The concerns mean it's important to make sure you're in the right type of bond fund.

For anyone who won't need the money for five years, an intermediate-term bond fund may make sense. "But if they're investing that tuition payment or for that spring vacation," a money-market account or a short-term certificate of deposit make more sense, says USAA's Freund.

Otherwise the risk is too high that when it comes time to withdraw, interest rates may be moving higher and bond prices falling due to forced selling as other investors withdraw their money.

"You will always be able to get out of your bond mutual funds, you will always be able to sell your ETFs," Freund says. But the price you get will depend on how liquid the market is.