How Redemptions and Bond Liquidity Can Affect Fund Investors
Summary
The document examines whether investors who remain in a bond fund can lose value because other shareholders redeem during a market decline. A stylized example tracks a fund through a bond price shock, redemptions by half its holders, and a subsequent recovery in bond prices. Under the example’s assumptions, the manager sells a proportional share of the holdings at current market value, so the remaining investors participate in the recovery without an additional loss from the sale itself.
The author identifies a possible source of dilution: bonds may have to be sold at a liquidity-driven discount, while redeeming investors receive a price based on a fund valuation that does not reflect those sale prices. A portfolio example illustrates how selling half the bonds without transaction costs preserves the remaining portfolio’s proportional value when prices recover. The document poses questions about real-world frequency and magnitude but does not answer them with evidence. It therefore outlines a mechanism and a simplified illustration, not an empirical estimate of redemption risk across bond funds.
Key ideas
- Redemptions alone need not reduce remaining investors’ proportional claim if assets are sold at their fair market value.
- Liquidity discounts on forced bond sales can create losses for investors who remain in a fund.
- A mismatch between redemption pricing and realized sale prices may transfer value between redeeming and remaining shareholders.
- The example assumes no transaction costs and does not establish how large the effect is in actual funds.
Tags
Full text
# Is there such a thing as "sell-off risk" in bond funds?
# Is there such a thing as "sell-off risk" in bond funds?
Popular yet generally academically-grounded commentators such as Annette Thau and Larry Swedroe have claimed that there is the possibility for "sell-off risk" in bond funds. By this they apparently mean that shareholders in the bond fund who do not sell experience losses as a direct result of other shareholders selling their shares in a period of steep market losses.
Here's an example to illustrate:
Say that stay-the-course owners (we'll call them type H, for holders) own 50% (\$500k) of a \$1mm bond fund. Panicky owners (type P) own 50% (\$500k) of the fund.
Then bond prices somehow drop a historically-unprecedented 50%, to \$500k total assets in the fund. In response the P owners panic and liquidate all their holdings.
The fund manager has to sell holdings to meet redemptions. They sell...50% of the bonds the fund owns, which are worth \$250k. Which means the type H 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 H 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.
The only mechanism I can conceive of by which this might happen is through a wide spread due to liquidity constraints, combined with imperfect accounting (e.g. the sellers are given the NAV of the fund computed under ideal circumstances, rather than the sale price of the bonds that were sold as a result of their fund sale).
Main question: Does this effect happen in the real world?
Follow-up to main question: If it does, how large an effect is it? Is there any data that would allow this sell-off risk to be bounded?
Covering-all-the-bases question: Are there any other mechanisms by which this sell-off risk could occur?
Example
Consider a fund comprised of ten bonds (R code provided):
```
> library(maRketSim)
>
> mkt1 <- market(market.bond(i=.05), t=0)
> prt <- portfolio(
+ bonds=lapply( rep(seq(2,10,2),2), Curry(bond, mkt=mkt1) ),
+ mkt=mkt1,
+ name="Portfolio"
+ )
> prt
Portfolio 'Portfolio' created at time 0 containing 10 bonds.
i (%) Maturity Par Coupon t
5.00 2.0 yr $1000 $25 0.0
5.00 4.0 yr $1000 $25 0.0
5.00 6.0 yr $1000 $25 0.0
5.00 8.0 yr $1000 $25 0.0
5.00 10.0 yr $1000 $25 0.0
5.00 2.0 yr $1000 $25 0.0
5.00 4.0 yr $1000 $25 0.0
5.00 6.0 yr $1000 $25 0.0
5.00 8.0 yr $1000 $25 0.0
5.00 10.0 yr $1000 $25 0.0
> summary( prt )
Portfolio 'Portfolio' of 10 bonds created at time 0. Current time is 0.
PV of portfolio is $10000
Duration of portfolio is 4.983404
Coupon yield is 5%
Coupon total is $500 per year.
N.B. Portfolio summaries do not include reinvested coupons or maturing securities. For that, place the portfolio in an account.
>
> # Then market rate rises
> mkt2 <- market(market.bond(i=.1), t=0)
> summary( prt, mkt=mkt2 )
Portfolio 'Portfolio' of 10 bonds created at time 0. Current time is 0.
PV of portfolio is $7891.38
Duration of portfolio is 4.497744
Coupon yield is 6.34%
Coupon total is $500 per year.
N.B. Portfolio summaries do not include reinvested coupons or maturing securities. For that, place the portfolio in an account.
>
> # Present value has dropped. In response, half the fund holders panic.
> # In response, the fund manager sells half the bonds in the fund.
> # Assuming no transaction costs.
>
> prt2 <- prt
> prt2$bonds <- prt2$bonds[1:5]
> prt2
Portfolio 'Portfolio' created at time 0 containing 5 bonds.
i (%) Maturity Par Coupon t
5.00 2.0 yr $1000 $25 0.0
5.00 4.0 yr $1000 $25 0.0
5.00 6.0 yr $1000 $25 0.0
5.00 8.0 yr $1000 $25 0.0
5.00 10.0 yr $1000 $25 0.0
> summary(prt2, mkt=mkt2)
Portfolio 'Portfolio' of 5 bonds created at time 0. Current time is 0.
PV of portfolio is $3945.69
Duration of portfolio is 4.497744
Coupon yield is 6.34%
Coupon total is $250 per year.
N.B. Portfolio summaries do not include reinvested coupons or maturing securities. For that, place the portfolio in an account.
>
> # Then the market rate returns to its previous value
>
> summary(prt2, mkt=mkt1)
Portfolio 'Portfolio' of 5 bonds created at time 0. Current time is 0.
PV of portfolio is $5000
Duration of portfolio is 4.983404
Coupon yield is 5%
Coupon total is $250 per year.
N.B. Portfolio summaries do not include reinvested coupons or maturing securities. For that, place the portfolio in an account.
> # And so does the fund value
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.