“Bondholders are sometimes accused of being the worrywarts of the investment world. But this time, they may have a point,” writes Aaron Lucchetti in today’s Wall Street Journal.

“Traders and investors — many of whom now believe the Federal Reserve will move its short-term target interest rate higher by this summer, pushing down bond prices — are growing concerned about how well prepared Wall Street and other parts of the financial system are to weather the shift.”

“There won’t necessarily be trouble this time, but ‘if you look back at history, whenever the Federal Reserve starts a cycle of raising interest rates, somebody blows up,’ says Michael Cheah, portfolio manager at AIG SunAmerica Asset Management in Jersey City, N.J. ‘We always learn something new.’ “

“While much of the impact of rising interest rates would likely be felt in the credit markets, it could also affect the stock market, especially if interest rates rise more sharply than anticipated. Stocks are generally valued on interest rates and earnings, and the recent period of remarkably low interest rates has underpinned rising stock prices. But the era of soothingly low rates looks close to over.”

“Mr. Cheah and other trouble hunters are focused on the private market for trading interest-rate derivatives, the financial instruments that sophisticated investors use to reduce their exposure to big moves in interest rates. That market is dominated by large banks such as J.P. Morgan Chase & Co. and Bank of America, which have sharply increased their sales of such instruments in recent years, particularly to mortgage giants Fannie Mae and Freddie Mac.”

“Some analysts are now concerned that the combination of massive demands from Fannie and Freddie and the concentration among banks dealing in this market adds up to potential systemic stress in the financial world. In a March report, Credit Suisse First Boston analysts warned that three dealers — J.P. Morgan, Citigroup Inc. and Bank of America — ‘have substantial exposure to changes in the level and volatility of interest rates’ as a result of huge positions in the market for interest-rate options. (These options are essentially contracts giving buyers the right but not the obligation to buy or sell securities such as Treasury bonds at a price that is based on interest rates.)”

“The worst thing that can usually happen to a buyer is that the option expires and is worthless; he then loses the upfront fee, or premium, he has paid the seller. Sellers, on the other hand, can be exposed to cascading losses if interest rates move sharply against them and they haven’t properly hedged their positions.”

“The CSFB report points out that Wall Street dealers had exposure to $844 billion worth of interest-rate options they sold as of last June, up more than threefold since 1999. The overall level of derivatives held by these dealers has also soared.”

“The analysts wonder about what might happen if one of the top dealers in this market has financial problems and is forced to stop buying and selling interest-rate options.”

“As interest rates rise, ‘Will these markets remain sane and liquid?’ asks James Bianco, head of Chicago research firm Bianco Research. ‘That’s what nobody knows and what everyone is wondering.’ “

“That said, Federal Reserve Chairman Alan Greenspan recently said banks appeared well prepared to deal with a rising interest-rate environment. And many investors have also positioned themselves for higher rates.”