Sitting Bucks: Zero Returns in Fixed Income Funds
60 Pages Posted: 23 Sep 2018 Last revised: 1 Dec 2018
Date Written: November 20, 2018
Zero returns are highly common in fixed income funds: on over 30% of trading days, NAVs do not change. These extreme occurrences of no price moves are driven by high illiquidity of fund holdings, and further compounded by binding minimum ticks. This is particularly prevalent among municipal bond funds, where more than 85% of holdings do not trade on any given day. We show that for funds with a high prevalence of zero returns, NAVs are extremely stale, and future returns are easy to predict using past fund returns at the daily, weekly, and even monthly horizons. Investors exploit this phenomenon by responding to stale prices and more importantly, by withdrawing capital from overvalued funds holding illiquid securities, which can exacerbate the risk of fund runs, as investors can achieve a first-mover advantage by redeeming at overvalued NAVs. This happens at the expense of buy-and-hold investors, who lose from others opportunistically buying and selling at predictably incorrect prices. Our results reveal shortcomings in existing fair valuation methods that are supposed to solve this problem.
Keywords: Fixed income mutual funds, Portfolio holdings, Illiquidity, Return predictability, Fund flows, Municipal bonds
JEL Classification: G11, G14, G23
Suggested Citation: Suggested Citation