Do Corporate Bond Mutual Funds Follow their Mandates?

Do Corporate Bond Mutual Funds Follow their Mandates?

Robert Manolache? 9th August 2018

Abstract I find that the investment behaviour of corporate bond mutual funds is consistent with their investment mandates, despite limited enforceability of mandates. Funds spend more on corporate bonds with credit quality or maturity characteristics that best satisfy mandate criteria. For example, if a mandate states that the fund targets a longer portfolio maturity than other funds, the fund invests significantly more in long-term bonds. The findings of my study apply to overall investment expenditure, as well as to how funds spend each incremental unit of flow, regardless of whether the investment occurs on the secondary or primary market.

? The University of Melbourne, Department of Finance, email: b.manolache@student.unimelb.edu.au

1. Introduction

After the financial crisis of 2008, corporate bond mutual funds gained substantial ground in the delegated asset management industry. In stark contrast to the $1.085 trillion net outflow experienced by equity mutual funds between 2009 and 2017, corporate bond mutual funds attracted a record $664 billion net inflow.1 As investors entrust more of their savings to corporate bond mutual funds, it is essential to investigate how the funds invest this money. An obvious point of reference is a fund's investment mandate, as described in the fund's prospectus to investors. The mandate specifies the general portfolio characteristics (e.g. credit quality, maturity) that a fund intends to maintain. Though the literature provides some theoretical insight as to how fund managers are incentivised to follow their mandates (He & Xiong, 2013), little is known about how mandates are executed in practice. To address this, I examine the extent to which the portfolio decisions of corporate bond mutual funds reflect their investment mandates.

In the mutual fund industry, managers are typically rewarded (penalised) if the fund's return is above (below) the return of a benchmark portfolio, where the benchmark is chosen to reflect the fund's mandate. He & Xiong (2013) show how, in theory, such compensation incentives align portfolio decisions to the fund's mandate. Other studies point out that managerial compensation also depends on the size of the fund (Starks,

1 Figures are based on Table 21 of the 2018 Investment Company Institute Fact Book (page 228), which may be found at . I aggregate the net flows for domestic-oriented mutual funds only and exclude government, multisector and municipal bond fund categories.

- 1 -

1987; Ma, Tang, & G?mez, 2018). To avoid outflows, fund managers may not want to expose their clients to unexpected risks from investments that are not consistent with the fund's mandate. On the other hand, superior performance attracts investor flows.2 Some managers may thus attempt to enhance performance via investments outside the fund's mandate. Almazan, Brown, Carlson & Chapman (2004) highlight that only some of the prospectus statements that describe a mutual fund's investment mandate are legally binding. Therefore, fund managers can make substantial departures from stated mandates if it suits their purpose.

To shed light on what happens in practice, I investigate whether the investment behaviour of corporate bond mutual funds is consistent with their mandates. In short, the evidence strongly suggests that this is the case. The average investment expenditure of corporate bond mutual funds is higher for the bonds that best fit their mandate criteria. In addition, funds also spend more of their inflows on these bonds. In most cases, these results hold separately for secondary market bonds and for bonds that are newly issued.3 My findings are not only reassuring for investors who rely on mutual fund

2 Corporate bond mutual fund flows are positively related to past performance, as measured by riskadjusted returns (Chen & Qin, 2016; Goldstein et al., 2017), as well as raw returns (Choi & Kronlund, 2017). 3 The distinction between seasoned bonds and new issues is important, as funds' investment behaviour may differ across secondary and primary markets. The secondary market for corporate bonds is often characterised as illiquid and costly (Bessembinder et al., 2018). On the other hand, it is less costly to invest in new corporate bond issues, especially if the issues are underpriced (Cai, Helwege & Warga, 2007). Therefore, it is possible that the primary market is the preferred setting for corporate bond mutual funds to execute their mandate.

- 2 -

prospectuses to make portfolio choices, but also have important implications for clienteledriven corporate finance.4

To identify corporate bond mutual fund mandates, I rely on Lipper objective codes. Each code corresponds to a distinct category of funds, where each category is associated with a specific mandate. The mandates differ in terms of: (i) the required credit quality of bonds in a fund's portfolio or (ii) the target portfolio maturity. To examine whether funds abide by their mandates, I use quarterly holdings to approximate5 how much each fund spends on corporate bonds across several distinct market segments. To reflect the mandate criteria, I delineate corporate bond market segments by credit quality or maturity.6 The goal is to gauge whether, within each segment, the observed differences in funds' investment activity align with the differences implied by their mandates. To ensure comparability, I divide the analysis in two samples: (i) funds with different credit quality mandates (but no maturity restrictions) and (ii) funds with different maturity targets (but the same credit quality requirements).

4 We may consider corporate bond mutual funds as the clientele of corporate issuers of public debt. If issuers intend to cater to corporate bond mutual funds, then the funds' mandates should be an important consideration. This is relevant for studies that examine the role of mutual funds as suppliers of debt capital (Massa, Yasuda, & Zhang, 2013; Zhu, 2018), as well as for the broader supply-side corporate finance literature (Baker, 2009). 5 Since I do not observe a fund's transactions, I approximate expenditure on each bond using the quarterly change in face value held by the fund (adjusting by the bond's market value where appropriate). 6 That is, each segment contains corporate bonds that meet certain credit quality or maturity specifications.

- 3 -

There are three Lipper objective categories for credit quality mandates with no maturity restrictions. A-rated funds' stated focus is on bonds rated A or better, BBBrated funds' stated focus is on bonds rated BBB or better, and HY funds' stated focus is on bonds rated BB or below.7 Correspondingly, I define three corporate bond segments: high-quality (rated A or better), medium-quality (rated BBB) and low-quality (rated BB or below).

Mandates suggest that, relative to BBB-rated funds, A-rated funds invest more in high-quality corporate bonds and less in medium- and low-quality corporate bonds. However, funds in these two groups are statistically similar in how they invest in the high-quality segment. Nevertheless, where results are statistically significant, the two groups differ as expected in the medium- and low-quality segments. These differences are sufficient to ensure that A-rated funds maintain a higher portfolio credit quality relative to BBB-rated funds, by a margin of approximately one S&P rating notch.

The minor difference between A-rated and BBB-rated funds may be attributed to their overlap in segment focus. As HY funds' segment focus is mutually exclusive to that of BBB-rated funds, differences between HY funds and BBB-rated funds are more pronounced. Relative to BBB-rated funds, HY funds spend, on average, 8.15% of total net assets (TNA) more on low-quality corporate bonds, and 3.31% and 4.98% of TNA less on high- and medium-quality corporate bonds respectively. To highlight the relative

7 Unless otherwise stated, any credit ratings in this paper are broad S&P ratings.

- 4 -

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download