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Let’s Talk About Bond Fund Redemptions

Some of the bond pickers of the world were not very happy with my recent post talking about how bond funds are generally safer than owning individual bonds.¹ The most common response I saw was similar to this comment on Seeking Alpha about the risk of redemptions:

Beyond diversification, you have the impact of potentially permanent capital impairment as a fund sells bonds in order to, say, raise money for even normal redemptions. This risk can be particularly acute if there is a run on a fund or, even worse, a bond rout. This is not to say one would not see the same mark to market effect with their directly held bonds. The difference is that in the case of directly held bonds, the investor retains the option of either selling or holding the bonds through to maturity.

First off, we should be clear that a “redemption” is just another word for selling. When you redeem shares in a bond fund you are effectively telling the bond manager to sell on your behalf. This is really no different than initiating the order on your own except that you’ve hired a bond manager who likely has more experience and better behavior implementing trades in these markets. Again, a bond fund is just the summation of all its individual holdings and orders to buy/sell a bond fund are just orders to buy and sell a whole bunch of individual bonds using a fund manager as the middleman.

Second, I would point out that bond funds do have an average effective maturity date. For instance, if you buy the Barclays Bond Aggregate you’ll note that it has an average effective maturity of about 8 years.² If you hold that fund for 8 years the average holding will have matured which means that there is a very low chance that this fund will incur principal losses over an 8 year holding period. While it is not exactly the same as holding a single 8 year bond that matures at par it is functionally the same except that you’re taking less credit risk in the case of the aggregate over the course of those 8 years.  So, if your bond fund’s holdings are under pressure you still have the option to ride out the storm and let the markets normalize. If you own high quality underlying instruments there is very little reason for long-term worry. In fact, if you own a well diversified bond fund the odds are that you’re far less exposed to risk than you would be in a similarly volatile market in which you own individual bonds. The fact that the individual bond matures in 8 years does not make it safer than the aggregate index whose average holding will mature in 8 years.

Lastly, selling and especially forced selling is always a risk in financial markets. This isn’t a unique feature in bond funds, however, it can be exacerbated in certain illiquid funds. For instance, there was a case in recent years where a highly illiquid junk bond fund experienced huge redemptions which forced the manager to close the fund so they could better control the sale of assets. But we should again be clear about cases such as this – this is not a product error as much as it’s a product misuse where the manager is exposing investors to highly illiquid positions in a concentrated fashion. Product wrappers don’t kill portfolios but portfolios can be killed by people who misuse product wrappers. If we are buying funds for the purpose of diversifying away single entity risk then owning a fund that is concentrated in illiquid junk bonds really defeats the whole purpose.

So here’s the thing –  we own “funds” for the primary purpose of taking advantage of their ability to scale and diversify where it would be unaffordable for us to do so on our own. Yes, there are funds out there where the managers are misusing the product wrapper. This is true in many of these leveraged volatility funds, concentrated bond funds and many others. But the fact that some product wrappers are misused does not mean they are all worse than their individual holdings. And in fact, if you own a diversified and high quality bond fund and use that fund over an appropriate time horizon a bond fund should be safer on average than trying to pick the individual bonds on your own.

¹ – I really shouldn’t generalize so much, but who wants to read a 30 page formal research diatribe about bond markets and bond market liquidity except for Matt Levine

² – The Aggregate Bond Index is a good starting point for these generalizations since it is the benchmark for most bond funds. There are, of course, funds that reflect the basic goals of the aggregate very well and funds that do not. But the fact that some fringe funds are misuses of the fund’s intended benefits does not take away from the broader fact that funds, on average, are superior products to owning individual bonds.  

NB – In addition to the behavioral risk of the price transparency in bond funds the other major risk is managing your sequence risk since the nice thing about individual bonds is that we can buy them to cover specific time periods. With a bond fund you basically own a constant maturity bond portfolio which means that, for instance, in our example above, you might not have a constant 8 year time horizon if you’re invested in the bond aggregate and so you could be forced to liquidate during a bond market downturn because you don’t really have a 8 year time horizon in perpetuity.

NB Deux – It’s worth noting that mutual funds are usually the unfair target of these “redemption” scare mongering stories. But the fact is, there has never been a broad run on the bond mutual fund space. Even in 2008 there was no broad run on the sector. Hedge funds and prime money market funds experienced some liquidity troubles, but aside from some sector specific liquidity woes the mutual fund industry handled 2008 extremely well. This is because of two primary factors:

  1. The majority of mutual fund assets are held in retirement accounts which have inherently long-term and less speculative style holders.
  2. Mutual funds have cash mandates and large cash positions on average that have averaged about 10% over the last 15 years.

 

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