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Bonds are supposed to be the boring part of most portfolios, but there is no shortage of controversy surrounding them lately. Now, a new academic paper says
Morningstar
is getting faulty data, a claim the investment research firm disputes.
The faulty data can cause Morningstar (ticker: MORN) to misclassify bond funds and misapply its widely known star ratings, which, in turn, can cause investors to make bad decisions, according to the paper titled “Don’t Take Their Word for It: The Misclassification of Bond Mutual Funds.” It was written by Huaizhi Chen of the University of Notre Dame, Lauren Cohen of Harvard Business School, and Umit Gurun of the University of Texas at Dallas. The authors arrived at their conclusions by comparing summary fund reports against funds’ actual holdings.
Morningstar rates each fixed-income fund by putting it into a style box “based on measures of risk, together with assigning to other forms of categorization,” according to the paper.
Morningstar does have a “style box” for bond funds, capturing the underlying holdings’ credit and duration risks, but the firm said in response to the paper that the box isn’t used to place funds in its category scheme.
Morningstar’s bond style box expresses a fund’s two main characteristics—overall credit quality (high, medium, low) and duration (long, moderate, short)—as opposed to its categorization system, which assesses a fund’s holdings more finely.
For example, funds in Morningstar’s high-yield, or junk-bond, category and multisector category will both check the low-credit-quality box. But the junk-bond fund will have its entire portfolio in junk bonds whereas the multisector might have, say, 35% of its portfolio in junk bonds. (The firm’s famous style box for stock funds measures capitalization—large, mid, or small—and investment style—value, blend, or growth.)
In addition to confusing the bond style box for bond fund categories, Morningstar says that the discrepancies the authors describe are eliminated when nonrated bonds are accounted for. Some entities have credit ratings, while the securities they issue don’t, Morningstar explains. In that case, a fund company may justifiably apply a rating to the holdings, but Morningstar will show the holdings as “not rated.” The result is higher levels of nonrated bonds than those self-reported by fund companies.
But the authors, replying to Morningstar’s response, say the data still suggest misclassifications in the categorization system, regardless of the style box-categorization issue, and that discrepancies still occur when analyzing funds with no nonrated bonds in their portfolios.
As debt issuance proliferates and boomers continue to retire, shifting their portfolios to fixed income and seeking yield, the issue of what’s in a bond fund is likely to become more, not less, contentious.
Write to John Coumarianos at John.Coumarianos@barrons.com
