Image Credit: Christophe Vorlet
By Jason Zweig | 2:40 pm ET Sept. 18, 2015
The Federal Reserve didn’t raise interest rates this week. But when rates finally do go up, how worried should you be that a panic by other investors might tank your bond fund?
A new Wall Street research report argues that long-term investors in high-yield or “junk” bond mutual funds could take a hit if too many others yank their money out during a market downturn. While the results would probably be much milder in all but the worst markets, the research is still a reminder that the less liquid the investments a fund holds, the more careful you should be in evaluating it.
The report, by analysts at Barclays, estimated that if the junk-bond market fell 10% and investors in a mutual fund asked for 20% of their money back, the fund would drop by about 12% — significantly worse than the 10% market decline.
That’s because the portfolio manager would first sell the securities that are most liquid, or easiest and cheapest to trade: cash, U.S. Treasury debt and other high-quality securities. The fund’s remaining, lower-quality investments, would be harder to price, and some might not trade at all in a severe decline.
So not all the fund’s least-liquid holdings would have fully adjusted to the market downdraft; they might be carried on the fund’s books at higher prices than conditions warrant.
As a result, anyone selling immediately would be cashed out at a slightly overstated value, while the remaining holdings — owned by all the investors who stay in the fund — would later get marked down as prices catch up with reality. The investors who stick around effectively subsidize those who leave.
In theory, that could lead to a self-fulfilling prophecy in which every investor seeks to get out while the getting is still good.
“Investors could withdraw money en masse if expectations about other investors’ behavior shifted dramatically, and that could be disruptive to prices over a short-term window,” says Jeffrey Meli, co-head of research at Barclays in New York and a co-author of the report. He and his team looked at the trading costs and past returns of the individual bonds in the Barclays U.S. High Yield Index, then estimated how they would react in market declines. It can easily cost 3% or more to sell less-liquid junk bonds–far more than the trading costs on high-quality corporate or government bonds.
Because of that potential friction, “I don’t think it makes sense to run a big [purely] high-yield mutual fund,” says Daniel Fuss, manager of the $20 billion Loomis Sayles Bond Fund, which has about 28% of its assets in junk bonds. For a fund specializing in junk bonds, he says, forced selling is “a little bit like being Napoleon going the other way in Russia, retreating slowly and trying not to get rid of everything you prize.”
However, for these effects identified in the Barclays report to be large, the disruptions in the market have to be huge. How likely is a one-day 10% market drop and a simultaneous demand from investors to redeem 20% of the fund’s assets?
According to John Hollyer, head of investment risk management at Vanguard Group, the worst daily return on high-yield bonds during the financial crisis was minus 4.7% on Oct. 10, 2008; the most they have ever lost in a month, dating back to 1983, was 15.9%. Investors have never withdrawn even 5% of total assets from high-yield bond funds in a single month since 1993, he says.
Ryan Taliaferro, a portfolio manager at Acadian Asset Management in Boston, which invests about $70 billion, has studied comparable effects at mutual funds investing in U.S. stocks and found that in rare cases they can amount to as much as 0.2% of a fund’s value. But, he says, “most of the time for most investors, except in the most dire of situations, it’s not likely to be a big deal.”
Overall, the less liquid a mutual fund’s holdings — besides junk bonds, some examples might be municipal or emerging-market debt and small stocks in the U.S. or overseas — the more it matters who else owns the fund.
You should favor exchange-traded funds over mutual funds; the managers of ETFs don’t have to raise cash to satisfy departing investors. And before buying any mutual fund, spot-check its size over time: If billions of dollars have gushed in after good performance, and billions more have sloshed out when returns went cold, it may be overpopulated with investors who will try to stiff you on their way out.
Source: The Wall Street Journal
http://blogs.wsj.com/moneybeat/2015/09/18/if-investors-bail-will-your-bond-fund-flail/