This past weekend, the Wall Street Journal published an article in its Business and Finance section about what happens if interest rates rise and holders of bond mutual funds and ETFs start to sell in large amounts. The article is based on a research report written by Barclays and co-authored by that firm’s co-head of fixed income research, Jeff Meli. The article isn’t identified further.
Maybe that’s not so strange, since, as reported in the WSJ, I find the research itself to be weird. Its conclusions seem to me to be either not that relevant or just plain wrong. The article does, however, touch on a number of points that are important for bond fund holders to consider.
The report starts out by assuming what I guess the researchers think is a worst-case scenario: the junk bond market drops 10% in a day, and a given mutual fund receives requests for redemptions equal to 20% of its assets.
It concludes that:
–the fund’s net asset value would fall by 12%
–the fund would sell its most liquid assets to meet redemptions
–the remaining assets would be mispriced at a value higher than the value they could be sold at
–therefore, the first investors to leave would receive more than fair value and would be the best off; later redeemers would get less than fair value for their shares
–ETFs don’t have these problems and should be preferred to mutual funds.
I think this is a very unlikely set of circumstances. The most damning constraint would seem to be the “single day” provision, which is intended to give the junk bond manager in question the least possible time to raise funds to meet redemptions. However, the other two conditions haven’t come anywhere close to being triggered on a single day, either in the downturn following the internet bubble or during the 2008-09 recession. Some kind of gigantic external shock to the economy would seem to be necessary for either to happen– not something specific to a given type of asset.
In such a case, it’s not clear that any financial markets would be functioning normally. It’s conceivable that trading in many/all financial instruments would be halted until calm was restored. So the pricing of a given junk bond fund would be a moot point.
For at least the past quarter-century, junk bond funds have generally been priced by third parties at “fair value.” I’ve seen them work for illiquid stocks or for NY pricing of stocks trading abroad. My judgment is that they work incredible well. So I don’t think fast redeemers get the best pricing. The opposite may well be the case.
Fund families have lines of credit that they can use to meet unanticipated redemptions.
No portfolio manager worth his salt is going to sell only the most liquid assets first. On the contrary, it’s better to sell illiquid ones while there are still buyers.
In the past, big investment companies have ended up buying the most illiquid assets from junk bond funds they manage at a price determined by a neutral third party, in order to make redemptions easier and shore up confidence in the fund.
In general, fund management companies have no incentive to price a fund too high. If anything, they should want to price it too low. That way, they can send the extra to redeemers once they find their error. No one is going to send anything extra back.
I don’t get the ETF stuff at all.