# 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

-
The term "sell-off risk" is a misnomer. It is econ 101, when there is more supply than demand the price must adjust in order to reach a new equilibrium, whether it be bananas or bonds. And I can tell you exactly when we will witness a powerful and broad bond market selloff/panic, which is the day when inflation will pick up and it has become too late to tame the beast because all that money that has been printed is floating around. Sell-off risk is nothing else than directional exposure when you really look at it –  Matt Wolf Jul 9 '13 at 0:17
As Matt mentioned in the comment there is no specific "sell-off risk" of bond funds and "sell-off risk" as you describe is just a directional exposure. Even if you sell with other shareholders you are still exposed to market impact risk, i.e. risk that knowing about large scale sell-off market participants will exploit it ("predatory trading"). This can also be related to "imperfect accounting" that you mention. –  Alexey Kalmykov Jul 9 '13 at 8:48
@MattWolf Please keep comments/answers specifically focused on the damage to continuing shareholders from others selling. The inflation panic stuff is pretty far off topic. Of course selling when the market is down is going to cost you money--it's the difference between holding a fund and holding the bonds directly that interests me. –  Ari B. Friedman Jul 9 '13 at 12:33
@AriB.Friedman, again there is no difference, when people sell assets that comprise a portfolio that you invest in then the asset itself as well as the portfolio will suffer. With the generic information you have given it is impossible to tell how the returns between such individual bond and the bond fund will differ. –  Matt Wolf Jul 9 '13 at 13:21
@AlexeyKalmykov "Even if you sell with other shareholders you are still exposed to market impact risk" -- I don't care about the sellers; I care about those who continue to hold the fund. –  Ari B. Friedman Jul 9 '13 at 18:14