Would a rose under any other name smell so sweet? This is a question that many bond investors and managers of their money should ask themselves.
A bomb paper which has gradually made its way through the peer-reviewed academic publishing process has now finally appeared in the latest edition of the venerable Journal of Finance, and deserves wide circulation.
Sifting through the reported individual investments of individual bond funds, Huaizhi Chen, Lauren Cohen, and Umit Gurun found that nearly a third of supposedly safe U.S. bond funds are actually riskier than their classification would suggest. The appropriate title of the article is: “Don’t Take Them at Their Word”.
Overwhelmingly, the three researchers say it appears to be a deliberate ploy to play with the rating system of Morningstar, the mutual fund industry’s dominant research house. “These false claims have not only been persistent and widespread, but also appear to be strategic,” the newspaper said.
Let’s break this down. Most bond funds focus on a specific corner of the fixed income markets, for example, corporate or government bonds, investment grade debt securities or securities rated below, and often a certain maturity of the debt. Morningstar then awards them stars based on their performance against other funds in their category.
But in reality, many bond funds classified as relatively safe have actually loaded riskier debt to optimize their returns relative to their peers and the benchmark, according to the document. This means they get a brighter rating from Morningstar, which in turn leads to a growing influx of investors who are simply following its influential rating system. When categorized appropriately, many fund managers go from appearing as proverbial masters of the universe to more “mediocre performers,” the newspaper notes.
The report focuses on the gap between a bond fund’s actual holdings and its Morningstar rating, and primarily criticizes the former for seemingly misrepresenting and the latter for believing them.
Morningstar argues that the paper mistakenly assumes that all unrated debt must be of low quality, and may confuse its investment style and classification systems with the latter used to assign ratings. When the research house tried to recreate the study, it found no significant relationship between so-called “misclassified” funds and Morningstar ratings.
However, whatever the relative merits of the arguments on this particular article, it is probably a much larger and more pernicious problem than many realize.
As AQR Capital Management showed in a 2018 article titled The illusion of active fixed income alpha, the phenomenon of bond funds flattering their results by taking on riskier debts is generalized. In fact, this simple and systematic slant towards lower-rated corporate debt explains why bond funds, on average, beat their indexes much better than equity funds, argued the AQR.
The quantitative investment group also looked for signs of reasonably consistent investing skills within the different bond fund categories. âThe evidence is pretty grim: we see little evidence of a continuing competence of managers,â the document concluded.
This is one of the reasons passive investing flourishes in the bond markets. In the past five years, passive bond funds have garnered nearly $ 850 billion, even more than the much larger universe of active bond funds, according to EPFR. For many traditional investors, this is a travesty. They argue that passive bond funds are dumb at best, given the lucrative inefficiencies of the fixed income market, and bond ETFs are downright dangerous. But investors are clearly voting with their money.
It is true that one could argue that overweighting corporate bonds, and in particular lower-rated bonds, is a natural and indeed smart move by active managers who are paid to deliver higher returns, in particular. especially at a time when high quality government bond markets are returning near to or even below zero.
But the reality is that it transforms the nature of a bond fund. Riskier and more volatile unwanted bonds mean they move more in tandem with the stock market. This is fine if it is sold transparently as a sleeker vehicle, but can come as a nasty surprise to many investors who buy bond funds as a counterweight in their portfolios.
“When the tide receded in the initial shock of Covid, many managers were not fully dressed,” says Mike Gitlin, head of fixed income at Capital Group. One of the roles played by fixed income managers, he observes, should be to make sure that you don’t “push clients out of the way when they need you the most.”
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