A new report suggests there is often hidden risk U.S. bond funds that isn’t being represented by their classification. Robin Wigglesworth reports in the Financial Times:
Would a rose by any other name smell as sweet? It is a question many bond investors should be asking themselves and the managers of their money.
A bombshell paper that has been gradually wending 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 a wide airing.
Sifting through the individual reported investments of individual bond funds, Huaizhi Chen, Lauren Cohen and Umit Gurun found that almost a third of supposedly safe US bond funds are actually riskier than their classification would imply. The fitting title of the paper is: “Don’t Take Their Word For It”.
Damningly, the three researchers say it appears to be a deliberate ploy to game the rating system of Morningstar, the mutual fund industry’s dominant research house. “This misreporting has been not only persistent and widespread, but also appears to be strategic,” the paper argues.
Let us break this down. Most bond funds focus on a specific corner of the fixed income markets, say, corporate or government bonds, highly rated “investment grade” debt or securities rated below that, and often a certain maturity of debt. Morningstar then assigns them stars according to how well they do compared with other funds in their category.
But in reality, many bond funds classified as relatively safe have actually loaded up on riskier debt to juice their returns relative to their peers and the benchmark, the paper argues. That means they get a shinier star rating from Morningstar, which in turn leads to burgeoning inflows from investors that simply follow its influential rating system. When classified appropriately, many fund managers go from looking like proverbial Masters of the Universe to more like “mediocre performers”, the paper notes.
Read more here.