Stale Pricing and the Risk to Bond Fund Investors
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: