Research Brief

Unintended Consequence of Stale Corporate Bond Fund Prices Amid Fed Tightening

In wild markets, do the most dated prices actually reduce redemptions?

Bond fund investors were laid low by the Federal Reserve’s aggressive 4 percentage point increase of its target federal funds rate in 2022. The total return for the Bloomberg U.S. Aggregate Bond Index — reflecting the combined return of (rising) yields and (falling) bond prices — was minus 13%. Many investors didn’t sit tight. Nearly $200 billion flowed out of investment grade corporate bonds that year. Total bond fund flows were down nearly 10% for the year, more than three times the outflows from stock funds.

A working paper from INSEAD’s John Kuong, City University Hong Kong’s James O’Donovan and UCLA Anderson’s Jinyuan Zhang suggests that a quirk of bond fund pricing — namely stale price quotes, given that prices don’t adjust promptly when interest rates rise — initially can accelerate outflows from bond funds. But, in extreme situations of rising interest rates, interestingly, stale price data may instead serve to slow the outflow from funds, the authors show.

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There’s No Escaping Stale Bond Fund Prices

Unlike stock mutual funds, whose daily pricing is a reflection of the published end-of-day price of the individual stocks owned by the fund, the pricing of bond mutual funds is a fuzzier process. 

Many individual bonds don’t trade on a daily basis, or for multiple days, even weeks. Yet all bond mutual funds must report a share price for the fund — called the net asset value  —  at the close of each trading day. Often, the NAV is calculated using the outdated trading prices of the underlying bonds, leading to stale pricing. Kuong, O’Donovan and Zhang find that among the nearly 3,200 corporate bond funds they studied between 2009 and 2023, their NAVs do not move on 31% of days. 

In a rising interest rate environment, this delay can create a mispricing. If a fund is slow to incorporate new price information for a few days, its NAV becomes overpriced. Smart investors can capitalize on this by selling shares in the fund to take advantage of the overpriced NAV. And that is indeed what tends to happen, which can then trigger more fallout. Corporate bond funds don’t typically keep much cash or Treasury securities in their portfolio. Thus, if too many investors start selling before the NAV starts falling, it exacerbates the eventual adjustment, as the manager is likely forced to sell bonds (of declining value) to raise the cash needed to meet redemption requests. 

Kuong, O’Donovan and Zhang use daily flow data to study how this all plays out in the heat of Fed tightening. 

They focus on a short period before Federal Open Market Committee meetings, during which the Fed announces changes to the fed funds target rate. They observe that any new information about future changes in the fed funds rate is likely reflected in the movements of eurodollar futures, which are actively traded and incorporate the latest information. Investors monitor eurodollar futures, and if these futures exhibit a significant increase, they redeem shares from bond mutual funds. 

The more stale a fund’s NAV, the more it gets hit with the outflow whammy. The researchers find that, on average, a 0.25 percentage point increase in the federal funds rate triggers a 0.164% outflow from corporate bond funds in the four-day lead-up to FOMC meetings, equating to an annual outflow of 10.25%. Funds with higher-than-average NAV staleness experience an increase in outflows to 0.323%, which is double the average effect. This impact is on par with the 0.3% weekly outflows seen in bond funds during the COVID-19 crisis, as documented in a 2021 research paper by Antonio Falato, Itay Goldstein and Ali Hortaçsu.

That is in line with previous research on the effects of staleness. The smart money bails out before NAVs are updated to reflect falling bond prices. If the manager then needs to sell into a weaker market to raise cash for redemptions, the NAV then takes a bigger step down, which seems to induce the more patient fund shareholders to get antsy and sell as well. To be sure, staleness is not the sole reason shareholders sell. They also find that funds with lower liquidity (less cash/Treasuries on hand to cover redemption requests) have higher outflows. 

A Notable Exception to the Downward Spiral?

While staleness in NAVs contributes to outflow pressures on corporate bond mutual funds, it raises the question: Should policymakers aim to reduce the stale pricing of NAV? Surprisingly, the answer isn’t a clear yes. 

Kuong, O’Donovan and Zhang suggest that in periods of extreme market illiquidity, staleness may actually serve investors. This is because in an illiquid market, investors are primarily concerned with the costs imposed by others’ redemptions, leading them to redeem shares even when the NAV is below the fund’s intrinsic value. In such scenarios, higher staleness results in a more underpriced NAV, which in turn diminishes investors’ incentives to redeem. Empirically, they indeed find that staleness acts as a stabilizing force during periods of distress. 

The researchers write that this “helps explain why fund managers might not always want to update NAVs promptly,… In this sense, we point out the bright side of return smoothing.”

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About the Research

Kuong, J., O’Donovan, J. & Zhang, J. (2023). Monetary Policy and Fragility in Corporate Bond Mutual Funds.

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