A potentially serious anomaly among bond funds occurred in 2008. Corporate bonds are not traded on exchanges the way stocks are and so there is a degree of judgement involved in valuing them. During the credit crunch, it appears that corporate bond fund managers valued the same bonds at significantly different prices, resulting in larger than expected variances for funds holding similar assets. This should even out in the long run, but investors who bought or sold bond funds during the credit crunch may have been disadvantaged, while others may have received an unfair advantage--driven simply by the time of their transaction.
Anecdotal feedback from fund managers with whom Morningstar has spoken suggests that, at its widest point, this anomaly may have accounted for up to 13% in performance--a huge amount for any fund but even more so for a bond fund.
Bond Pricing: A Brief Primer
First it’s necessary to understand how trading differs between bonds and equities.
Equities trade on exchanges such as the London Stock Exchange or New York Stock Exchange. Corporate bonds are not traded on exchanges, so there is no market-recognised price. Bonds are traded ‘over the counter’ usually with the aid of a broker who sits between buyers and sellers. The broker is typically one of the large investment banks such as Barclays, JP Morgan or HSBC. Essentially this means bonds are traded behind closed doors and investors have less clarity about what a particular bond is worth. Fund managers typically receive a daily price list (or feed) from index providers such as iBoxx and Merrill Lynch and they base the unit price of their fund on the prices provided in the feed.
So What Happened During the Credit Crunch?
During the credit crunch, some very illiquid bonds were not traded for weeks at a time. In this instance feed providers may retain the same price on a bond day after day. This is known as a stale price, because although it may reflect the last known transaction, the market may have moved significantly since then, and the price might not represent what a bond could actually be sold for.
It’s difficult to get hard facts on this. Those closest to the market, such as fixed income fund managers, are generally in the best position to evaluate what is going on. Recent conversations between fixed income managers and Morningstar analysts revealed that transactions often occurred at significantly lower prices than were being quoted in pricing feeds, particularly at the height of the market’s problems in the third and fourth quarters of 2008.
So What Did Fund Managers Do to Get Around This Problem?
While some managers continued using the feed prices, others chose to ignore the price feed and value some bonds in their portfolios at what they believed to be more realistic prices--painting a fairer picture for their unit-holders. This is known as manual pricing and FSA guidance specifically states managers should undertake it in cases such as occurred last year:
FSA Handbook, COLL Sourcebook 6.3.6G.4 and 6.3.6G.5
Where the authorised fund manager has reasonable grounds to believe that:
(a) no reliable price exists for a security at a valuation point; or
(b) the most recent price available does not reflect the authorised fund manager's best estimate of the value of a security at the valuation point
it should value an investment at a price which, in its opinion, reflects a fair and reasonable price for that investment (the fair value price);
The circumstances which may give rise to a fair value price being used include:
(a) no recent trade in the security concerned; or
(b) the occurrence of a significant event since the most recent closure of the market where the price of the security is taken.
In (b), a significant event is one that means the most recent price of a security or a basket of securities is materially different to the price that it is reasonably believed would exist at the valuation point had the relevant market been open.
Managers who used feed prices that did not reflect the value of the security could have overstated the performance of their funds. They may have suffered less downside during the credit crunch, but received less upside in the market recovery since then. This would benefit investors who redeemed from funds during the credit crunch and may have disadvantaged investors who remained in the funds.
The managers who used manual prices would have arguably reflected a more accurate level of unit pricing during the credit crunch, losing more during the downturn, but rebounding more strongly during the recent recovery.
Encouragingly, feedback from fund managers in 2009 suggested that pricing feeds had improved since the depths of the credit crunch. Liquidity has returned to the market and this reduces the frequency of stale bond prices. But, seeing different fund groups adopt varying pricing methods for the same assets is far from ideal. Exacerbating the problem was that very little information has been made public about this issue, meaning investors do not generally know what pricing method was used in their fund. Even though the system has improved since then, it doesn’t help those investors who traded in or out of a bond fund during the credit crunch and may have been disadvantaged.
Bonds are unlikely to be traded on a centralised exchange any time soon. This is because unlike stocks--where each company typically has a single line of shares which are all identical--companies may have multiple tranches of bonds on issue, all with different interest rates, payment terms and maturity dates. It’s not uncommon for mega-cap companies to have thousands of different bonds all with varying terms and conditions.
Neither manual pricing nor feed pricing is perfect--although the former is better insofar as it represents clear effort to get the correct price, it does introduce a subjective element that can itself create issues. With no apparent likelihood of moving to an exchange-traded system in the near future, probably the best outcome for investors is to improve transparency and disclosure. Knowing what unit-pricing method a fund manager uses, and what sort of impact this has had on a fund’s unit price and performance, should help investors and advisers with their decisions. It may just improve competition among fund managers to ensure best-practice, too--which has to be a good thing.
A version of this article first appeared on Morningstar.co.uk in November 2009.
