The Bond ‘Misclassification’ Debate

Art by Guille Manchado

Almost two years into “a conversation” between the National Bureau of Economic Research and Morningstar as to the proper classification of the latter’s bond funds, there is still no resolution.

In November 2019, the bureau published a paper in its working paper series: “Don’t Take Their Word for It: The Misclassification of Bond Mutual Funds.”

The authors reported key findings that, if true, raise some tricky questions for the mutual fund analysis and reporting industry. Specifically, the authors stated that bond fund managers are prone to misclassifying their holdings, to the extent that these misclassifications have a real impact on investor capital flows—and on the amount of risk bond investors take.

The study compared Morningstar bond fund reports with various funds’ actual portfolio holdings, as the three authors studied and identified them. The authors found “significant misclassification of fund riskiness across the universe of all bond funds, with up to 31.4% of all funds misclassified in recent years.”

“Many funds report more investment-grade assets than are actually held in their portfolios to important information intermediaries, making these funds appear significantly less risky,” the report warns.

According to the researchers, the funds were aiming to earn a higher credit-quality rating in the oft-consulted Morningstar Fixed-Income Style Box. If the fund manager reported a BBB-portfolio—while still holding many BB-bonds—the fund could move into the medium credit-quality tier. Assuming the usual positive correlation between risk and return, the misclassified BBB-rated fund could potentially show a higher yield and more upside potential than its correctly classified BB-peers. The authors also maintain that “misclassified funds receive significantly more Morningstar stars than [do] other funds.”

In the retirement planning world, star ratings matter. Plan advisers interviewed here say they frequently use Morningstar’s analyses, including star ratings, when considering which bond funds to propose for a retirement plan’s lineup. Other research shows participants tend to rely “blindly” on such ratings when evaluating their plan’s bond funds.

The working paper attracted attention after its publication, and the authors and Morningstar’s research staff held a conference call to discuss the findings. Morningstar subsequently published a series of critiques, which the authors rebutted. Their disagreements remained unresolved, as the paper’s final draft was published in August’s peer-reviewed “Journal of Finance.”

Self-Reported Data

Bond funds often hold hundreds of securities with a wide range of covenants, maturity dates, yields and other features, even among bonds from the same issuer. Additionally, credit-rating agencies can differ on a security’s creditworthiness, assuming a bond is rated at all.

The key point for the authors was that Morningstar asks each bond fund it tracks to provide a monthly summary report of its holdings—a system, they say, the company relies on to rate the funds and that can invite abuse. Funds hence misclassified, they add, can charge significantly higher expenses and attract more investor flows.

Jeff Westergaard, Morningstar’s fixed-income data director, says he is confident in the data’s quality, referring to the “tens of thousands of these surveys” they receive and the comprehensive data each collects.

Morningstar published responses in November and December 2019, asserting the authors incorrectly presumed all self-reported unrated bonds were low quality and possibly misunderstood how Morningstar classifies funds. The company uses the categories to peer-group, rank and assign ratings to funds, while the authors’ sole focus was on the fixed-income style-box assignments.

“Once we’ve assigned funds to Morningstar Categories, we can compare and rank them on measures such as past performance. To assign star rating, we rank funds’ trailing risk-adjusted returns against those of other funds in their Morningstar Category (the Morningstar Risk-Adjusted Return Rank),” the response said.

According to Morningstar’s December reply, the company had asked the authors to list the funds they considered misclassified and to classify them properly, but the authors said they could not, “as they’d defined ‘misclassification’ based on funds’ style box, not Morningstar Category, assignments.”

Morningstar’s published conclusion is, “We have found no evidence that bond funds have been incorrectly assigned to Morningstar Categories in the way the authors allege.”

As of early September, Morningstar still lacked a clear idea of what data or methodology the authors used to reach their conclusions, Westergaard says. “We did ask them to share this, and they declined to do so.” The authors’ published response: “We are using Morningstar’s data, along with Morningstar’s published formulas for calculating all of the weightings and classifications in the paper.”

Two of the authors agreed to discuss their findings, with PLANADVISER, but subsequent messages with specific questions were unanswered by deadline.