By Ryan Derousseau
Updated: November 7, 2019 10:46 AM ET

Bonds are supposed to be safe. But new research suggests some bond mutual funds may be riskier than they seem.

Millions of Americans own bond mutual funds in their 401(k)s or other retirement portfolios. By providing a fixed stream of investment income, they are supposed to serve as a counterweight to more volatile stocks. Now a new academic study published by the National Bureau of Economic Research suggests many investors in actively managed bond mutual funds may be taking on more risk than they realize.

The study examines the way popular fund researcher Morningstar Inc. classifies bond funds according to risk. While many individual investors and financial advisers rely on Morningstar’s famous star-rankings to help design portfolios, researchers claim that Mornignstar misclassifies risks for roughly one-third of actively managed fixed-income funds with high or medium credit ratings — usually making them appear safer than they really are.

Morningstar didn’t immediately respond to a request for comment. However, the Chicago-based research firm published a response saying it stands by its rankings and arguing that the researchers misinterpreted they way it ranks and classifies funds, among other things.

Morningstar didn’t immediately respond to a request for comment. However, the Chicago-based research firm has previously said it stands by its rankings. Morningstar also questioned the researchers’ methodology, according to correspondence provided to Money by the researchers, who acknowledged Morningstar’s objections but did not think they were material to the results.

The new paper examines 1,294 fixed-income funds from 2003 to 2019, using Securities and Exchange Commission filings to compare funds’ actual holdings within the funds to Morningstar classifications. It found that in 99% of misclassified cases, the fund received a safer risk profile than it should have by Morningstar.

The impact of the misclassification could be worrisome for investors. Bond funds typically offer investors a trade-off between credit quality and yield — essentially the interest rate investors can expect from holding a portfolio of bonds. In general, bonds with lower credit quality offer higher yields to compensate investors for the higher possibility of losses.

Investors rely on Morningstar’s rankings to find funds with the highest yields for the level of risk they are willing to accept. Misclassified funds could attract millions in investment dollars if investors believe attractive yields are the result of bond fund portfolio managers’ skill in picking bonds — rather than simply taking on bigger risks.

In other words, some bond funds look better than they really are because they’re competing against “too easy of a peer group,” warns Lauren Cohen, a co-author of the report and a professor at Harvard Business School.

 

A Change in 2010

So how could funds be getting away with it? The study authors claim a rise in risk misclassifications started in 2010 after Morningstar made a switch in how it scores bond funds, putting increased focus on relative default rates. This switch appears to have incentivized fund managers to claim they carried safer bond holdings when responding to Morningstar surveys, according to the authors.

One way Morningstar could address the problem, according to the researchers, is to rely less on fund manager surveys and more on holdings data reported by funds to Morningstar or the SEC. “Our most surprising finding by far,” says Cohen, “is Morningstar taking the funds’ word on the holdings.”

 

Why Funds Fib

The funds which underweight their risk profiles the most may not surprise you. The researchers found a trend that funds usually start to misrepresent their holdings in surveys with Morningstar after a period of underperformance. Once the performance improves, then the funds are more likely to represent their risk profile correctly.

Funds that were misclassified were often subpar, even when returns were compared to their actual peer group, researchers found. While misclassified funds tended to outperform their assigned Morningstar peer groups, when moved back to their actual peer groups they lagged by about 0.11 percentage points per quarter, the study found.

“It appears that 100% of the apparent outperformance of misclassified funds is coming from being misclassified to a less risky comparison group of funds,” wrote the researchers.

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