Bond mutual funds trade daily and are highly liquid, but the underlying securities are often highly illiquid, trading very infrequently. This mismatch means that bond fund pricing is unreliable, creating risks, especially for buy-and-hold investors.
The bond mutual fund market has grown substantially in the years since the 2008 recession. But in the wake of the post-crisis banking regulations, the underlying market for corporate and municipal bonds has become increasingly illiquid, creating a mismatch between underlying bonds and open-end funds that hold those assets. The mismatch occurs because mutual funds must calculate daily net asset values (NAVs) when many bonds don’t trade for weeks.
Stale pricing can create problems for investors. For example, funds are incented to engage in “return smoothing” by selective use of valuations; those incentives are particularly strong for funds that have suffered from poor performance and when funds face higher risks of outflows. In addition, the liquidity mismatch between mutual funds and their underlying bonds subjects buy-and-hold investors to a first-mover advantage that exacerbates the risk of runs1 – to the extent that NAVs are stale, opportunistic investors exploiting NAV mispricing will further amplify the risk of runs.
Jaewon Choi, Mathias Kronlund and Ji Yeol Jimmy Oh, authors of the study, “Sitting Bucks: Stale Pricing in Fixed Income Funds,” published in the August 2022 issue of the Journal of Financial Economics, analyzed the pricing challenges facing bond mutual funds and the resulting risks to investors. Their data sample included 4,551 U.S. fixed-income mutual funds for the period October 1998-September 2020. Their tests relied on the idea that if fund prices are stale, they would expect to observe strong positive autocorrelation in fund returns, particularly in asset categories with low trading activity – the municipal bond and high-yield (HY) segments – because the prices of previously nontraded assets in a portfolio will eventually be updated in the same direction as those of similar recently traded assets. Following is a summary of their findings:
Their findings led Choi, Kronlund and Oh to conclude: “Our results show further that stale prices result in substantial dilution risk for buy-and-hold investors and can exacerbate the risk of fund runs, thus contributing to the growing literature that studies the fragility of fixed-income funds.” They added the following caution: “Whereas the potential for a fund run induced by costly liquidation of illiquid securities remains even if fund NAVs are accurate, we point to an even more severe problem: fund values can be predictably wrong over long periods and investors also appear to be aware of this; they respond more strongly to a temporary overvaluation in addition to poor recent performance. Stale NAVs can thereby further exacerbate the fragility of bond funds, making it a cause for concern from a financial stability perspective.”
Investor takeaways
One important takeaway from these findings is that existing fair-value practices are insufficient to eliminate staleness in bond NAVs. Another is that while investors in municipal and HY bond funds focus on credit risk and expense ratios, they also need to consider the fund’s trading costs (bid-offer spreads, commissions and market impact costs) and, as Choi, Kronlund and Oh demonstrated, the risks and costs of stale pricing. Because their results showed that at least some investors are aware of staleness in fund pricing and seek to exploit it, long-term investors bear all the expenses. In addition, investors should consider that stale pricing increases the risks of a run on a fund during periods of distress, causing forced sales into illiquid markets.
Bond investors can avoid the risks and costs created by stale pricing in mutual funds by either building their own individual portfolios or engaging a separate account manager.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
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1 For example, because bond prices are stale and rates have gone up, the first ones to get out of the fund benefit from the stale prices. The remaining fund holders will have to absorb the costs of the mispricing when it is eventually revealed.
Read more articles by Larry Swedroe
Bond mutual funds trade daily and are highly liquid, but the underlying securities are often highly illiquid, trading very infrequently. This mismatch means that bond fund pricing is unreliable, creating risks, especially for buy-and-hold investors.
