by Cynthia Harrington
Recent charges by the Securities and Exchange Commission against Heartland Advisors and related parties have expanded regulators’ attention from equity to bond funds. The charges stem from a $93 million drop in pricing as the fund manager sought to correct what the SEC alleges was a period of deliberate mis-pricing of holdings.
Heartland subsequently denied the charges and stated on their Web site that they no longer manage the funds in question and that the people directly involved with the trading are no longer affiliated with the company. They also denied the insider trading charges leveled against the firm’s executive team.
But as a result, advisors across the country are questioning whether this is one bad apple, or are others in the fund barrel also rotten? The problem is one of liquidity.
Not all bonds trade every day. Funds update pricing of holdings when securities trade. Therefore, no trade, no update.
“There are two variables in the transparency of fund pricing. One is liquidity or how many participants are actually buying and selling the security,” said Asha Joshi, CFA, managing principal of Payden & Rygel Investment Management, in Los Angeles. Payden & Rygel manages $50 billion in stock and bond mutual funds. “The other is whether the security trades on an exchange with either open outcry or someone standing behind the bid and ask prices.”
Unlike most equities, there’s no real exchange for bonds. “When you have less liquid assets you’re dealing with the elements of the art and science of it,” says Joshi. “And of course integrity is involved.”
Even without the exchange, most bonds held by fund companies do trade every day, so a fresh price is available. “There are no real mis-pricing issues with the investment grade side,” said Andrew Clark, senior research analyst with Lipper, a Reuters Co., in Denver. “But in the high-yield area, as high as 50 percent of funds could experience pricing problems.”
Not all advisors are affected by the potential problems with the high-yield fund area. Increasingly, advisors buy individual issues for clients. “We buy funds only for smaller accounts,” said Peter F. Bauer. CFA, CPA, and president of Oakbrook Financial Group Inc., in Oak Brook, Ill. “Then we stick with high-grade corporates or governments.”
Bauer said that their goal is to own the individual bonds so investors know what the maturity date will be. Oakbrook Financial both buys bonds individually and uses separately managed accounts. “We buy fixed-income issues that are priced daily,” Bauer said. “Our clients have daily access to their accounts via our Web site. If one of their holdings shows up without a price, they’ll contact us for an explanation.”
Bond funds hold $1.2 trillion of the $7.2 trillion in domestic mutual funds, and spotting any apples about to go bad takes some investigation. All investment assets fall somewhere on a spectrum from most to least liquid. At the most liquid end might be large cap stocks and T-bills; at the least liquid are art, jewelry or venture capital.
“Just in the world of bonds there’s a spectrum,” said Joshi. “Certain bonds trade less frequently. Munis are notoriously a negotiated market. Then, within the high-yield area, and even emerging markets, some are quite liquid.”
“There are times when the liquidity dries up in U.S. corporate bonds. When Enron was going through its problems, who knew what the prices of their bonds were?” said Joshi.
Placing the specific bond fund along the spectrum of liquidity is a first step in determining the potential mis-pricing risk. “If the fund buys D-rated bonds or distressed debt, it’s foolish to expect a price on each issue every day,” Joshi said. “With these types of bonds you’re not going to have that one component of transparency, which is that someone is willing to pay a certain price for these bonds each and every day.”
Fund pricing and performance can give some clues to potential problems. Funds that perform far under or over the returns of peers might be succeeding because of stale prices of their holdings. “Financial professionals should look at performance numbers with professional skepticism and grill managers for outperformance as much as for underperformance,” said Joshi. “It’s fair to ask how the manager achieved that number. No portfolio manager is a magician. If the advisor doesn’t feel comfortable with the movement or lack of movement in price, they should verify what the manager did.”
The lack of movement in pricing could be a tip-off to pricing problems. Clark advises that advisors look back over a reasonable period of time — every day for a quarter, for instance. “If the NAVs don’t change for more than five days at a time, call the fund to see what’s going on before investing,” he advises. “In the high-yield or emerging markets, I’ve seen funds go for up to 20 days without a change in their published NAV.”
The bond mis-pricing issue might be on the horizon for regulators. So far, Heartland Advisors is the only target of formal charges, but the case brings the issue to the foreground. A potential solution would be to force bond funds to mark to market on a weekly basis. One way to establish frequent pricing on illiquid bonds would be to compare single issues as closely as possible to one of the indices. Both Citigroup and Merrill Lynch provide weekly index prices on various kinds of high-yield bonds.
“This would add to the issues of transparency for investors,” said Clark. “If funds are required to update pricing on illiquid holdings they’d have to disclose to investors which method they used.”
Nor are the pricing services above reproach. In the Heartland charges, FT Interactive, an independent pricing service, was charged with aiding and abetting and causing certain Heartland pricing violations.
Advisors may not be as concerned about how to clean up fund companies as those whose charge it is to look out for small investors. “Funds have probably reached the saturation point,” said Bauer, “We see a trend back to basics, to investors buying individual stocks and bonds.”
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