Sell-Off Risk in Bond Funds

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Call_Me_Op
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Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 12:17 pm

I have been trying (without complete success) to determine whether there is a reality to the phenomenon referred to as "Sell-Off Risk." This is purportedly a distinct risk associated with bond funds. The story goes as follows. Consider a bond fund that contains some illiquid bonds. There is a rush to the exits by (generally novice) investors in the fund. The fund manager must meet redemptions by raising cash. He must therefore sell bonds. As the selling pressure increases, he will be forced to sell some relatively illiquid bonds. Because there may be few if any buyers, the price of the bonds must be lowered significantly. This much I fully understand.

The above explains why the value of the fund will fall significantly while there is selling pressure. It does not explain why someone who doesn't sell will be hurt by this - compared to someone who holds the same bonds outside of a fund. If the fund holder must take a loss that the holder of individual bonds does not experience, then "Sell-Off Risk" is real.

One possibility is that the fund manager, in his effort to raise cash, must sell more bonds than necessary in order to meet redemptions (because he cannot predict how many redemptions will be recorded by end of the day). Therefore, more bonds than necessary will be sold and this will cause a loss for the investors that remain invested in the fund (as well as those who flee). The fund is selling low, and some of those losses are sustained by those who remain invested in the fund.

A second possibility is that the trading commissions are higher on illiquid bonds, because they are harder to sell. I do not have sufficient experience with bond investing to know whether this is the case.

Or both could happen - or neither. Any input as to whether "Sell-Off Risk" is real and (if real) elucidation of the underlying mechanism would be appreciated.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 12:55 pm

Hi Op,

It might help to document your sources that talk about this sell-off risk -- links to what you know so far.

I would not be concerned with the first effect, too much selling vs. the actual redemptions. The cash not used for redemptions stays in the fund and can be used to buy back bonds the next day, or even in the last minutes of the market day. At better or worse prices, but that should balance out.

The second effect I'm sort of interested in. As a concrete testable prediction, it seems to suggest ETFs would outperform mutual funds during a sell-off in illiquid bond markets, because ETFs directly charge the sellers for the liquidity cost (in the form of a discount to NAV). Does this happen?

Finally, the effect would apply equally to stock funds dealing with illiquid markets; there is nothing specific to bonds in what you just said. So far it seems that e.g. small cap funds manage just fine by charging slightly higher fees.

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 12:57 pm


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Re: Sell-Off Risk in Bond Funds

Post by steve roy » Wed Jul 03, 2013 1:02 pm

A fund manager can't buy and hold through a rough patch if he has to honor redemptions. Forced to sell when bond values are down, it's not pretty:
As investors prepare for a long-term shift in interest rates, few large financial firms are as vulnerable as the giant money manager Pimco. ...

In the last few weeks, Pimco’s leaders have shown their awareness of the threat by churning out opinion articles in the financial news media and making frequent television and radio appearances. On Thursday, Mr. Gross, Pimco’s guiding light, sent customers a letter titled “The Tipping Point” that used the metaphor of a ship in danger of sinking.

“Yell, ‘This ship’s going to make it to port,’ Fed, Pimco and Pimco co-captains willing,” Mr. Gross wrote, adding, “Have a cocktail, tell the band to stop playing dirges, because you’re gonna be just fine with Pimco at the helm.” ...

In recent months ... Mr. Gross made another bad bet on Treasury bonds, leading the Total Return Fund to even bigger losses than the bond market as a whole. This time, it looks like investors might be a little less forgiving. Only two of the 20 Pimco E.T.F.’s tracked by Lipper attracted money in June, and one of those was its low-risk, low-fee money market fund. ...

http://dealbook.nytimes.com/2013/07/01/ ... iness&_r=1


Of late I've noticed (because I own some of it) that PIMCO Total Return has lost more value than many of Vanguard's bond index funds. It could be that PIMCO will have issues with liquidating positions at bad times because they have to make good to the folks leaping overboard.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 1:06 pm

I certainly agree that fund managers hate sell-offs from their funds. It makes the fund look bad (probably triggering even more selling), lowers their fees, and it makes investor returns bad permanently (the figure that takes into account when each past investor bought and sold). They might even take some harsh actions to stop the bleeding, e.g. lower duration

None of these except the last one are a concern of the remaining investors. So choose your manager wisely. And, again, everything just said applies equally well to stock funds.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 1:07 pm

ogd wrote:Hi Op,

It might help to document your sources that talk about this sell-off risk -- links to what you know so far.
No problem. Larry Swedroe discusses "sell-off risk" (but doesn't use that term) on page 194 (third paragraph) in his book "The Only Guide for a Winning Bond Strategy". Also, Annete Thau discusses it (and uses that term) in "The Bond Book."
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Re: Sell-Off Risk in Bond Funds

Post by SimpleGift » Wed Jul 03, 2013 1:11 pm

Call_Me_Op wrote:It does not explain why someone who doesn't sell will be hurt by this - compared to someone who holds the same bonds outside of a fund. If the fund holder must take a loss that the holder of individual bonds does not experience, then "Sell-Off Risk" is real.
For a case study in sell-off risk (aka liquidity risk), see what happened to the Schwab Yield Plus Fund (SWYPX) in March, 2008. The fund managers couldn't sell their holdings easily and quickly, so the fund slipped into a downward spiral. The holdings were so illiquid that the losses spurred redemptions, then these redemptions spurred more losses as the fund managers tried to sell securities at fire-sale prices.

The fund's NAV fell every single day, even when similar bond funds were experiencing gains — so sell-off or liquidity risk is indeed real, even though it's a bit rare in modern markets.
Cordially, Todd

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 1:14 pm

Thanks for the link, linux. As you can see from it, I was struggling with this same question back in 2009.
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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 1:15 pm

steve roy wrote:A fund manager can't buy and hold through a rough patch if he has to honor redemptions. Forced to sell when bond values are down, it's not pretty.


This discussion will be a lot more productive if we can avoid vague claims like "selling when bond values are down, it's not pretty."

Specifics, please.

As with every fund, you own a portion of its holdings. Say you own $10k (1%) of a $1mm fund. Like-minded owners (we'll call them L) own 49% ($490k) of the $1mm fund. Panicky owners (P) own 50% ($500k) of the fund.

Then bond prices somehow drop a historically-unprecedented 50%, to $500k. In response all those cretins flee: the P owners all sell.

The fund manager has to sell in response. They sell...50% of the bonds they own, which are worth $250k. Which means you and the type L owners now own 100% of a $250k fund.

The next day, Bernanke utters the magic word, and bond prices are restored. You and the type L owners now own 100% of a $500k fund.

"Sell-off risk" is any risk that at the end of the day, the 100% of the fund that you and the type L owners now own is less than $500k. There does seem to be some mechanism by which this could happen. It appears to be very limited in the conditions under which it could happen, and even then the amount of money lost seems to be fairly small. If we could have discussion about that phenomenon, rather than general doom-saying about bonds, that would make this thread incredibly useful.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 1:17 pm

Simplegift wrote:
Call_Me_Op wrote:It does not explain why someone who doesn't sell will be hurt by this - compared to someone who holds the same bonds outside of a fund. If the fund holder must take a loss that the holder of individual bonds does not experience, then "Sell-Off Risk" is real.
For a case study in sell-off risk (aka liquidity risk), see what happened to the Schwab Yield Plus Fund (SWYPX) in March, 2008. The fund managers couldn't sell their holdings easily and quickly, so the fund slipped into a downward spiral. The holdings were so illiquid that the losses spurred redemptions, then these redemptions spurred more losses as the fund managers tried to sell securities at fire-sale prices.

The fund's NAV fell every single day, even when similar bond funds were experiencing gains — so sell-off or liquidity risk is indeed real, even though it's a bit rare in modern markets.
Thanks SG. Do you think this was due to the fact that the fund held very illiquid bonds and all holders of those bonds would have suffered? In other words, did this have anything to do with investing in a fund, or did it have to do with investing in illiquid bonds?
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 1:18 pm

Call_Me_Op wrote:
Thanks for the link, linux. As you can see from it, I was struggling with this same question back in 2009.
As was I :-)

@Simplegift - Everything I've read about SWYPX indicates that they weren't really a bond fund so much as a leveraged, option-based fund with some bonds at the core. The price was justified--given the counterparty risk at the time, the options which made up the majority of the valuation really were worthless. I consider it a prime example of manager risk, but I don't see how it has much of anything to do with sell-off risk of bonds.

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Re: Sell-Off Risk in Bond Funds

Post by SimpleGift » Wed Jul 03, 2013 1:22 pm

Call_Me_Op wrote:Do you think this was due to the fact that the fund held very illiquid bonds and all holders of those bonds would have suffered?
If you held those same illiquid bonds outside the fund, you would not be compelled to sell — you could just wait until the market stabilized to decide what to do. The problem for a fund manager is that she's forced to sell, to honor fund redemptions — and this is where the downward spiral occurs, as best I understand it.
Cordially, Todd

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Re: Sell-Off Risk in Bond Funds

Post by SimpleGift » Wed Jul 03, 2013 1:33 pm

linuxizer wrote:@Simplegift - Everything I've read about SWYPX indicates that they weren't really a bond fund so much as a leveraged, option-based fund with some bonds at the core. The price was justified--given the counterparty risk at the time, the options which made up the majority of the valuation really were worthless. I consider it a prime example of manager risk, but I don't see how it has much of anything to do with sell-off risk of bonds.
The legal findings from one of the class-action lawsuits about Schwab Yield Plus (SWYPX) were:
Stoltman Law Offices wrote: 1. the Funds were and are not well-diversified and were concentrated in a single risky industry or market segment - in reality, over 50% of the Funds assets are now invested in the mortgage industry, and that percentage grew as Defendants abandoned the objectives of the Funds in pursuit of higher yields;

2. a material portion of all the bonds were issued by the Fund's top 10 broker dealers, who sold the funds shares;

3. there exists no primary market for most of the bonds, and in fact, the only market was, for many, the issuers themselves;

4. the duration of a vast majority of the bonds is greater that 2 years, with a majority of the bonds not having publicly available durations;

5. the Funds credit and market analysts did not have any real expertise in valuing the mortgage backed securities they purchased, or assessing the risk;

6. the Funds relied blindly on the ratings by agencies who were paid by the Funds' broker-dealers; and

7. the net asset values ("NAVs") of the Funds were highly speculative and inflated.
Cordially, Todd

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 1:34 pm

Simplegift wrote:
Call_Me_Op wrote:Do you think this was due to the fact that the fund held very illiquid bonds and all holders of those bonds would have suffered?
If you held those same illiquid bonds outside the fund, you would not be compelled to sell — you could just wait until the market stabilized to decide what to do. The problem for a fund manager is that she's forced to sell, to honor fund redemptions — and this is where the downward spiral occurs, as best I understand it.
Simplegift, please re-read linuxizer's post above. If the fund manager is forced to sell enough bonds to cover exactly the outgoing investors, however bad the price, that still does not affect the remaining investors. They will be made good when liquidity returns. Yes if you are the one selling into a bad market you take a loss -- same with individual bonds.

The real issue with High Yield Plus was that it was advertised as a risk-free account for cash. So when it started dropping, everyone rushed for the exits. If my checking account from which I'm supposed to make my mortgage took a 20% dive, with no FDIC insurance, I'd probably be beating a path to the door too.

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Re: Sell-Off Risk in Bond Funds

Post by rkhusky » Wed Jul 03, 2013 1:59 pm

It seems like Vanguard could use these statements from their prospectus to prevent a run on a fund
Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading. Under these
circumstances, Vanguard also reserves the right to delay payment of the redemption
proceeds for up to seven calendar days.
Emergency circumstances. Vanguard funds can postpone payment of redemption
proceeds for up to seven calendar days. In addition, Vanguard funds can suspend
redemptions and/or postpone payments of redemption proceeds beyond seven
calendar days at times when the NYSE is closed or during emergency circumstances,
as determined by the SEC.

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Re: Sell-Off Risk in Bond Funds

Post by rkhusky » Wed Jul 03, 2013 2:02 pm

ogd wrote: If the fund manager is forced to sell enough bonds to cover exactly the outgoing investors, however bad the price, that still does not affect the remaining investors. They will be made good when liquidity returns. Yes if you are the one selling into a bad market you take a loss -- same with individual bonds.
One way that existing investors could be hurt without selling shares is if the fund has bonds with a range of interest rates and the manager chooses to sell the highest yielding bonds first, thus lowering the overall dividend/share amount.

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 2:06 pm

rkhusky wrote:One way that existing investors could be hurt without selling shares is if the fund has bonds with a range of interest rates and the manager chooses to sell the highest yielding bonds first, thus lowering the overall dividend/share amount.
Nope. Market price for higher-yielding bonds will be higher, so the manager would have to sell fewer of them to satisfy the withdrawal demands.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 2:08 pm

rkhusky wrote:It seems like Vanguard could use these statements from their prospectus to prevent a run on a fund
Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading.
Ah, funky! Thanks for noticing that, rkhusky. So it seems that they reserve the right to effectively become an ETF when liquidity is too horrible.

That settles it for me -- as in, I'm not worried knowing that Vanguard has the means to make sellers pay for spreads if they really need to.

Call_Me_Op, unfortunately I cannot read those -- I don't have the books although I keep telling myself I should get Thau eventually as a reference. I maintain that you would hear more about the spreads issue if it was significant. In particular, ETFs providers would be all too eager to tout the ETF structure as the solution.

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Re: Sell-Off Risk in Bond Funds

Post by rkhusky » Wed Jul 03, 2013 2:23 pm

linuxizer wrote:
rkhusky wrote:One way that existing investors could be hurt without selling shares is if the fund has bonds with a range of interest rates and the manager chooses to sell the highest yielding bonds first, thus lowering the overall dividend/share amount.
Nope. Market price for higher-yielding bonds will be higher, so the manager would have to sell fewer of them to satisfy the withdrawal demands.
But the issue of liquidity may not be uniform across the bonds, i.e. for some reason the higher yielding bonds have become less desirable (fears of default, changing credit rating, rising interest rates).

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 2:24 pm

ogd wrote:I maintain that you would hear more about the spreads issue if it was significant. In particular, ETFs providers would be all too eager to tout the ETF structure as the solution.
This has been my instinct as well. I'd prefer a definitive answer on sell-off risk (although rkhusky's "in kind" find is a great one--thanks!), but absent certainty, I've settled for the lack of any evidence that the risk will be more than trivially small as my balm.

Still interested academically, but in terms of actual action, I think anyone who is appropriate for bond funds yet avoids them because they were warned about "sell-off risk" has been done a grave disservice. Magnitudes matter.
Last edited by linuxizer on Wed Jul 03, 2013 2:31 pm, edited 1 time in total.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 2:27 pm

rkhusky wrote:
linuxizer wrote:
rkhusky wrote:One way that existing investors could be hurt without selling shares is if the fund has bonds with a range of interest rates and the manager chooses to sell the highest yielding bonds first, thus lowering the overall dividend/share amount.
Nope. Market price for higher-yielding bonds will be higher, so the manager would have to sell fewer of them to satisfy the withdrawal demands.
But the issue of liquidity may not be uniform across the bonds, i.e. for some reason the higher yielding bonds have become less desirable (fears of default, changing credit rating, rising interest rates).
So clearly your manager could hurt you in a million ways, including investing everything in default swaps on an obscure London index. But he does have a way of selling that does not impact the remaining investors in either direction -- sell equally (by value) from all maturity points. So choose wisely -- a good conservative fund that never changes policy.

(I also find it funny that individuals are currently advised to shorten duration after this sell-off. I.e. hurt themselves in the same way that a misbehaving manager would. Go figure)

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 2:30 pm

rkhusky wrote:
linuxizer wrote:
rkhusky wrote:One way that existing investors could be hurt without selling shares is if the fund has bonds with a range of interest rates and the manager chooses to sell the highest yielding bonds first, thus lowering the overall dividend/share amount.
Nope. Market price for higher-yielding bonds will be higher, so the manager would have to sell fewer of them to satisfy the withdrawal demands.
But the issue of liquidity may not be uniform across the bonds, i.e. for some reason the higher yielding bonds have become less desirable (fears of default, changing credit rating, rising interest rates).
Ah, there you're on to something--back to the spreads argument. As you pointed out earlier, Vanguard has measures in place to protect against this, and I have to assume that a manager would be more interested in protecting shareholders than those liquidating. Indeed, in Vanguard's case, those selling are no longer owners of the management company, whereas those holding remain owners. Which would you rather keep happy?

Which brings up another point. There is always the risk of managers doing something terribly harmful. Somehow that risk seems greater with bonds than stocks. I am fairly firm agnostic when it comes to stock funds, but for bonds I would only use Vanguard at this point.

The manager risk comes not only from this sell-off risk but from other factors (my personal bug-bear is convexity, which is almost never published but which is definitely priced and could be manipulated by a cynical manager to get higher yield at any given duration while hiding the risk).

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 2:51 pm

linuxizer wrote:
ogd wrote:I maintain that you would hear more about the spreads issue if it was significant. In particular, ETFs providers would be all too eager to tout the ETF structure as the solution.
This has been my instinct as well. I'd prefer a definitive answer on sell-off risk (although rkhusky's "in kind" find is a great one--thanks!), but absent certainty, I've settled for the lack of any evidence that the risk will be more than trivially small as my balm.

Still interested academically, but in terms of actual action, I think anyone who is appropriate for bond funds yet avoids them because they were warned about "sell-off risk" has been done a grave disservice. Magnitudes matter.
Right - magnitudes do matter. But we really don't have an idea as to what order of magnitude we are dealing with here. Thau makes it seem like an important issue. I wrote to her today - but may be having trouble getting by her spam filter.
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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 2:54 pm

ogd wrote: Call_Me_Op, unfortunately I cannot read those -- I don't have the books although I keep telling myself I should get Thau eventually as a reference. I maintain that you would hear more about the spreads issue if it was significant. In particular, ETFs providers would be all too eager to tout the ETF structure as the solution.
ogd,

Sorry I do not have them in a form I can post.

BTW, I appreciate your clear and informed posts on bonds (across a number of recent threads).
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 2:57 pm

Call_Me_Op wrote:Right - magnitudes do matter. But we really don't have an idea as to what order of magnitude we are dealing with here. Thau makes it seem like an important issue. I wrote to her today - but may be having trouble getting by her spam filter.
Right.

Here's a general strategy by which we could characterize this:
  • Find a detailed explanation of the mechanism by which sell-off risk occurs
  • Find a worst-case historical scenario for the type of bonds that a well-managed bond fund would hold (e.g. the spreads on municipal bonds from XX city in YY year were 0.85%)
  • Figure out how that scenario would impact a bond fund, and how bond funds at the time handled it

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 2:59 pm

And, Op -- if you do get through, would you please ask whether Vanguard's redemption in kind policy above takes care of this issue in the more extreme cases.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 3:02 pm

Call_Me_Op wrote:
ogd wrote: Call_Me_Op, unfortunately I cannot read those -- I don't have the books although I keep telling myself I should get Thau eventually as a reference. I maintain that you would hear more about the spreads issue if it was significant. In particular, ETFs providers would be all too eager to tout the ETF structure as the solution.
ogd,

Sorry I do not have them in a form I can post.

BTW, I appreciate your clear and informed posts on bonds (across a number of recent threads).
You're welcome! I wouldn't be so vehemental about the bond funds scare if I didn't think it could cause real damage -- such as a 54 year old going to 80% stocks in the other thread.

Posting any significant amounts of book content here would probably violate the copyright policy anyway. I'll have to try to dig them up myself.

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 3:10 pm

Ditto re: nice posts ogd. You too, call_me_op.
ogd wrote:You're welcome! I wouldn't be so vehemental about the bond funds scare if I didn't think it could cause real damage -- such as a 54 year old going to 80% stocks in the other thread.

Posting any significant amounts of book content here would probably violate the copyright policy anyway. I'll have to try to dig them up myself.
While you're digging, look up some of Fabozzi's books. They're cheap on sites like half.com and really pretty thorough. I think I reviewed one or two of them if you look through the archives here.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 3:15 pm

linuxizer wrote:Ditto re: nice posts ogd. You too, call_me_op.
Thanks Linux. I recognize and appreciate your many highly-informed posts on this forum.
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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 3:26 pm

Call_Me_Op wrote:Thanks Linux. I recognize and appreciate your many highly-informed posts on this forum.
Alright, the back-patting has officially gone too far when we're thanking a bum like me :shock: . Thanks though.

Back on topic, I'm excited to see where this goes.

Larry has commented on this to me in the past, but I haven't found the post yet. As I recall, he briefly described the mechanism he was referring to in his book.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 3:33 pm

Agreed -- one more back-pat and then we're done :) thanks for the posts and the Fabrozzi reference, I'll definitely check him out too. I think I only have room for one bond book so it will be a competition.

Now back to worrying about those pesky emerging markets, where the real action is... One of them has been on CNN all day.

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 3:52 pm

ogd wrote:Now back to worrying about those pesky emerging markets, where the real action is... One of them has been on CNN all day.
Time for some LEAPS on VWO.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 3:59 pm

Ah I'm much more tame -- trying to decide when to TLH / rebalance and what to buy instead. Anyway -- off-topic. Happy 4th everyone!

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Re: Sell-Off Risk in Bond Funds

Post by linuxizer » Wed Jul 03, 2013 4:03 pm

ogd wrote:Ah I'm much more tame -- trying to decide when to TLH / rebalance and what to buy instead. Anyway -- off-topic. Happy 4th everyone!
Yeah I don't do LEAPS. Barely even slice'n'dice anymore. And my portfolio's tiny anyhow. 8-)

Happy 4th!

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 5:18 pm

linuxizer wrote:
Call_Me_Op wrote:Thanks Linux. I recognize and appreciate your many highly-informed posts on this forum.
Alright, the back-patting has officially gone too far when we're thanking a bum like me :shock: . Thanks though.

Back on topic, I'm excited to see where this goes.

Larry has commented on this to me in the past, but I haven't found the post yet. As I recall, he briefly described the mechanism he was referring to in his book.
Larry has told me in a PM that the effect is real, but his explanation was rather terse. He said something to the effect that it is due to increased expenses associated with selling into an illiquid market. He also indicated that he plans to write something on it - so I look forward to that.

Happy 4th back at yah's.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by Fryxell » Wed Jul 03, 2013 5:57 pm

My understanding is that this risk is caused by the higher bid/ask spreads, and by timing effects of when the selling occurs versus when the NAV value is calculated. For example, let's say the bond fund sells illiquid bonds with high bid/ask spreads at 12 noon. Because the bonds are illiquid, the act of selling them reduces the price of the bonds from, say, $500/bond to $400/bond. However, by the end of the day, when the heavy selling is over, the price of the bonds goes up back to $500/bond. At the end of the day the NAV is calculated based on the $500/bondprice. The fund shareholders are then redeemed based on the $500/bond price (not the $400/bond price), and the shareholders that did not sell would be absorbing the increased trading costs from selling in illiquid markets.

So to use the earlier example of a $1 million fund where 50% sell, and 50% hold tight: I assume the fund consists of 1,000 bonds valued at $1,000 each.

1. Price/bond declines to $500, so the fund is now worth $500,000.
2. Fund sells 500 bonds at 12 noon to meet redemptions, from 50% of the shareholders.
3. The fund's selling operations lower the price/bond to $400. The sale is executed and now we have a fund that owns $200,000 worth of bonds (500 bonds x $400 each), and has $200,000 in cash. The NAV of the fund is thus $400,000.
4. The fund stops selling operations, and the market becomes liquid. The price/bond rises back to $500.
5. The fund NAV is now back to $450,000. 500 bonds x $500 = $250,000; and $200,000 cash.
6. Sellers are redeemed for half of $450,000, or $225,000. Those that did not sell now own a fund with a NAV of $225,000.

Note that even though the price/bond recovered back to $500/bond, the NAV at the end of the day is $450,000 instead $500,000. Essentially, selling in an illiquid market incurred a transaction cost of $100/bond, or a total of $100,000. This cost is then split 50/50 between those that sold and those that did not sell.

Am I missing anything?

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ogd
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Re: Sell-Off Risk in Bond Funds

Post by ogd » Wed Jul 03, 2013 6:03 pm

Fryxell: yes, this is basically right. Note how it's not in any way specific to bonds, but any mutual fund trading in a highly illiquid market. But municipal bonds in particular happen to be one of those.

Things that would mitigate this effect: fund is allowed to take liquidity into account for NAV calculation; fund can successfully navigate illiquid market (including spreading its selling until the end of the day -- it's a mutual fund after all); fund is allowed to do in-kind redemptions if it determines the selling costs are too great. This last one IMHO solves the problem for good.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Wed Jul 03, 2013 6:15 pm

Nice. It looks like Fryxell has provided us with a plausible mechanism that could explain a risk specific to a fund versus holding individual securities. His explanation makes sense to me. To paraphrase, the sellers essentially force the sales to occur at a lower price than they get for their redeemed shares (since NAV is calculated based upon closing prices), and the rest of us are left holding the proverbial bag.

This can be thought of as an additional expense associated with mutual funds selling into illiquid markets. For buy-and-holders, is a fund-specific risk associated with the actions of other (less disciplined) shareholders.

Thanks Fryxell!

Note: Where Fryxell used the term "NAV" I would have preferred "fund value", since NAV usually represents the fund value divided by the number of outstanding shares.
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Re: Sell-Off Risk in Bond Funds

Post by steve roy » Wed Jul 03, 2013 7:05 pm

linuxizer wrote:
steve roy wrote:A fund manager can't buy and hold through a rough patch if he has to honor redemptions. Forced to sell when bond values are down, it's not pretty.


This discussion will be a lot more productive if we can avoid vague claims like "selling when bond values are down, it's not pretty."

Specifics, please.

As with every fund, you own a portion of its holdings. Say you own $10k (1%) of a $1mm fund. Like-minded owners (we'll call them L) own 49% ($490k) of the $1mm fund. Panicky owners (P) own 50% ($500k) of the fund.

Then bond prices somehow drop a historically-unprecedented 50%, to $500k. In response all those cretins flee: the P owners all sell. ...



Sure, panicky owners are going to take a hit if the fund declines ... because they will inevitably sell at the Wrong Time (i.e., The Bottom. They're cretins, as you say.) And the owners built of Stern Stuff will be fine because they'll tough out the fund's duration and be made, at the end of the game, whole.

But there's a wee bit of PO in all of us, no? Even bogleheads. Otherwise there wouldn't be so much hand-wringing here on the forum when markets go down. (And markets, sooner or later, always head for southern climes.)

I, myself, would never be so cowardly as to bail out of a fund simply because it's sinking like an anvil in the Salton Sea. I would, instead, decide all of a sudden that my asset allocation needs retuning, my IPS needs rewriting, and I would scurry to the new stock/bond percentages of my choosing. But bailing out? Surely you jest.

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Re: Sell-Off Risk in Bond Funds

Post by dumbmoney » Wed Jul 03, 2013 9:36 pm

I don't know what is meant by sell off risk, but certainly fund flows can damage share holders, especially if the NAV is wildly unrealistic. A too-high NAV will cause a "run" on the fund by sophisticated investors. After the fund's liquid assets are exhausted and the fund starts selling the illiquid assets, the NAV collapses, revealing the fact that the NAV was too high.
I am pleased to report that the invisible forces of destruction have been unmasked, marking a turning point chapter when the fraudulent and speculative winds are cast into the inferno of extinction.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Thu Jul 04, 2013 7:55 am

dumbmoney wrote:I don't know what is meant by sell off risk, but certainly fund flows can damage share holders, especially if the NAV is wildly unrealistic. A too-high NAV will cause a "run" on the fund by sophisticated investors. After the fund's liquid assets are exhausted and the fund starts selling the illiquid assets, the NAV collapses, revealing the fact that the NAV was too high.
I believe you meant to say "unsophisticated" investors.

Please see Fryxell's post above that explains the mechanics underlying the sell-off risk phenomenon.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by richard » Thu Jul 04, 2013 8:17 am

Fryxell wrote:My understanding is that this risk is caused by the higher bid/ask spreads, and by timing effects of when the selling occurs versus when the NAV value is calculated. For example, let's say the bond fund sells illiquid bonds with high bid/ask spreads at 12 noon. Because the bonds are illiquid, the act of selling them reduces the price of the bonds from, say, $500/bond to $400/bond. However, by the end of the day, when the heavy selling is over, the price of the bonds goes up back to $500/bond. At the end of the day the NAV is calculated based on the $500/bondprice. The fund shareholders are then redeemed based on the $500/bond price (not the $400/bond price), and the shareholders that did not sell would be absorbing the increased trading costs from selling in illiquid markets.

So to use the earlier example of a $1 million fund where 50% sell, and 50% hold tight: I assume the fund consists of 1,000 bonds valued at $1,000 each.

1. Price/bond declines to $500, so the fund is now worth $500,000.
2. Fund sells 500 bonds at 12 noon to meet redemptions, from 50% of the shareholders.
3. The fund's selling operations lower the price/bond to $400. The sale is executed and now we have a fund that owns $200,000 worth of bonds (500 bonds x $400 each), and has $200,000 in cash. The NAV of the fund is thus $400,000.
4. The fund stops selling operations, and the market becomes liquid. The price/bond rises back to $500.
5. The fund NAV is now back to $450,000. 500 bonds x $500 = $250,000; and $200,000 cash.
6. Sellers are redeemed for half of $450,000, or $225,000. Those that did not sell now own a fund with a NAV of $225,000.

Note that even though the price/bond recovered back to $500/bond, the NAV at the end of the day is $450,000 instead $500,000. Essentially, selling in an illiquid market incurred a transaction cost of $100/bond, or a total of $100,000. This cost is then split 50/50 between those that sold and those that did not sell.

Am I missing anything?
You're talking about market volatility more than bid-ask spreads.

As a practical matter, no single fund is going have that much of an impact on the market, almost all fund transactions are done by netting buyers against sellers rather than external trades and funds are managed to prevent this sort of problem. For example, the fund is not obligated to sell as soon as a sell order is made. At worst, the terms of mutual funds typically allow the fund to delay redemptions, just in case.

Consider that market prices of just about every security vary during a trading day. We've seen many days in which stock prices have moved up and down by more than a few percentage points, yet we don't see reports of this sort of problem. In fact, Vanguard index funds do an excellent job of tracking their indexes.

BTW, consider where the fund got the extra $25,000 needed to pay the sellers. Also, consider what happens if redemption orders come in late in the day.

Anything may be possible, but some things are highly unlikely.

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Re: Sell-Off Risk in Bond Funds

Post by Scooter57 » Thu Jul 04, 2013 8:45 am

There is so much speculation here. I'd feel more confident if someone who was personally familiar with the operation of bond funds could weigh in and explain exactly how these funds manage their investments when there is a wave of redemptions, rather than what they think or suspect or imagine the fund managers do in that situation.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Thu Jul 04, 2013 9:24 am

Scooter57: this one applies to mutual funds in general, not just bond funds.

Anyway, in practice Total Bond Market hugs its index so tightly it's downright creepy. And the index is a pure entity not affected by the panic selling of mortals. So it appears this simply isn't a problem in liquid markets.

We only see a couple of mentions of liquidity pricing effects in books as a possibility in the context of muni bonds. The fact that it's not more disseminated tells me the effect must be very small.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Thu Jul 04, 2013 9:36 am

Ogd,

Interesting comment regarding total bond and muni. People often suggest to substitute a muni fund for total bond in taxable. This is a rather questionable substitution in that the two have very different risk profiles.
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Re: Sell-Off Risk in Bond Funds

Post by ogd » Thu Jul 04, 2013 9:40 am

Hi Op,

Indeed -- the credit risk and the low liquidity should always be kept in mind. However, the rewards are so great (more than double!) in a high tax bracket that I can't resist it. I keep a separate stash of Treasuries and cash as rebalancing ammo.

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Re: Sell-Off Risk in Bond Funds

Post by Call_Me_Op » Thu Jul 04, 2013 10:12 am

ogd wrote:Hi Op,

Indeed -- the credit risk and the low liquidity should always be kept in mind. However, the rewards are so great (more than double!) in a high tax bracket that I can't resist it. I keep a separate stash of Treasuries and cash as rebalancing ammo.
Nothing wrong with calculated risks and wide diversification. I am still grappling with whether an allocation to muni's makes sense for me. I too am in a high tax bracket.

It's important for everyone to keep in mind that at the end of the day, a security is worth what someone is willing to pay for it. These risk factors are a way to attribute the price changes to specific factors - but bonds do not go down in value because interest rates go up. The interest rates go up because demand for the bonds decreases - and both interest rates and security values change in accord.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

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Re: Sell-Off Risk in Bond Funds

Post by Fryxell » Thu Jul 04, 2013 12:23 pm

richard wrote: BTW, consider where the fund got the extra $25,000 needed to pay the sellers. Also, consider what happens if redemption orders come in late in the day.
I'm not sure what you mean by the "extra $25,000." The fund NAV will be reduced at the end of the day, so the sellers will be paid their share of the reduced fund assets. I don't think the exact timing of the redemptions changes the basic mechanics that much. The key idea is that there is an arbitrage in price between when the fund may be forced to sell in illiquid or volatile conditions (at a lower price), and when the NAV is calculated (at a higher price). The sellers can take advantage of this by passing on the costs to those that did not sell. I believe Rick Ferri has stated that he uses bond mutual funds instead of bond ETFs for a similar reason: the bond EFTs can deviate from the NAV during intra-day trading in illiquid conditions:

http://www.rickferri.com/blog/investmen ... t-problem/
http://www.rickferri.com/blog/strategy/ ... bond-etfs/
richard wrote: Anything may be possible, but some things are highly unlikely.
I agree it's a very contrived and unlikely example. It was just meant as a proof of concept: to show how something like this could happen.

The main idea is that in mutual funds the transaction costs are shared by all shareholders (whether they sell or not). Likewise, deviations from when the securities are sold and when the NAV is calculated are also shared by all shareholders (whether they sell or not). In normal conditions the transaction costs are low, and there is little price deviation from when the securities are sold and when the NAV is calculated (and intra-day price deviations average out, as this intra-day price deviation can result in a gain for the fund just as much as in a loss). In extreme market conditions (such as 2008) and with illiquid securities (municipal bonds) such deviations may become significant enough to impose costs on shareholders that did not sell.

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Re: Sell-Off Risk in Bond Funds

Post by ogd » Thu Jul 04, 2013 12:38 pm

Fryxell wrote: The sellers can take advantage of this by passing on the costs to those that did not sell. I believe Rick Ferri has stated that he uses bond mutual funds instead of bond ETFs for a similar reason: the bond EFTs can deviate from the NAV during intra-day trading in illiquid conditions.
On the contrary -- if you're holding on, the ETF protects you from sellers, which are charged the full cost of liquidity and then some. The mispricing that you wrote about only applies to the mutual fund.

If you need to sell during crunch time, on the other hand -- a muni ETF is a really bad place to be. And so are individual munis.

Edit: I think this bears repeating every time: all of this applies to any fund, stock or bond, trading in a relatively illiquid market.

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Re: Sell-Off Risk in Bond Funds

Post by Munir » Thu Jul 04, 2013 1:06 pm

Does anyone know of specific Vangaurd bond funds that have experienced a "run on the bank"? Are there numbers to back up such large redemptions?

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