Bond Fund Classifications May Underrepresent True Risk

Many bond mutual funds may be riskier than they seem due to misclassifications of portfolio holdings by fund companies.

Many bond mutual funds may be riskier than they seem. Misclassifications of portfolio holdings by fund companies have led to approximately 30% of bond funds being “misclassified with safer profiles.” This has led to such funds being awarded a higher Morningstar rating than they deserve.

The claims were made by professors at three different universities. The study’s authors blame the misclassifications on the way that holdings are aggregated. Morningstar requires fund companies to state what percentage of holdings have specific credit ratings, such as AAA, AA, BBB, etc. Morningstar uses these reports to classify and rate the funds rather than checking against data from the U.S. Securities and Exchange Commission (SEC).

The authors assert, “This would be no issue if funds were truthfully passing on a realistic view of the fund’s actual holdings to Morningstar. Unfortunately, we show that this is not the case.”

Not surprisingly, most of the misstatements are one-sided. Nearly all of the misstatements make the funds appear safer than they are. This also leads to more favorable category comparisons. The misclassified bond funds realize quarterly returns that are 10.3 basis points (0.103 percentage points) higher than their peers. This equates to a 14% higher comparative return. Misclassifications also result in the funds being assigned an additional 0.34 stars in Morningstar’s 1-to-5 star rating system.

Misclassified bond funds tend to be more expensive. Their expense ratios are 9.98% higher than their peers.

Once adjusted to reflect the credit quality of their underlying bonds, their return advantage more than disappears. Such funds underperform their actual peers by 11 basis points per quarter.

In a response, Morningstar said the study’s authors made “inaccurate assertions about the role of self-reported data in assigning Morningstar Categories and the Morningstar Rating for funds.” The firm attributes the differences between the self-reported and Morningstar data to bonds classified as ‘not rated’ in its database. The firm further argues that bond funds have not been “systematically assigned incorrectly” and that the star ratings have been assigned correctly.

The study’s authors answered back by saying that misclassifications are, in fact, occurring. They offered to continue the dialogue with Morningstar.

Sources: “Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds,” by Huaizhi Chen, Lauren Cohen and Umit Gurun; National Bureau of Economic Research, November 2019; and “Morningstar Stands Behind Its Fixed-Income Data and Fund Ratings,” November 7, 2019.