Hedge Fund Bond Price Investigation Focuses on Thinly-Traded Bonds

Since bonds are rarely traded, pricing is difficult to verify, making it “ripe for abuse.”

Multiple sell-side hedge funds are being investigated by the Justice Department for misrepresenting thinly-traded bond prices to falsely boost returns and inflate their fees, according to news sources.

This market is “ripe for abuse,” according to Bloomberg reporter Matt Robinson. US Justice Department and SEC investigators had previously looked at similar abuses at equity funds and are now concentrating on bond funds where pricing is more opaque and difficult to value. The securitized bond debt markets, especially distressed bonds pools, rarely trade, so their pricing is more difficult to verify. This has made it difficult for prosecutors to get evidence or an independent quote to verify their claims that bond prices were falsely inflated.

While investigators continue to advance their cases, vendors are addressing the problem of thinly-traded bonds that has raised issues for both traders and compliance officers. According to a 2Q 2014 study using Federal Reserve data, only 1.8% of all bonds traded on a given day in that period, which marked a 45% decrease from the 2004 tally, according to Golden Source.  

Illiquid bond trading has serious ramifications, especially in determining accurate net asset value (NAV) for funds. When prices are wrong, they affect purchase and redemption transactions, inaccurate fund performance statements that damage the reputations of fund companies.

A July 2016 study (“Best Execution in Fixed Income”) by the Tabb Group found that when dealer quote data decreases, it makes it more difficult to determine a bond’s best price. When this occurs, the price discovery shifts to pre-trade and real-time price modeling. Pricing becomes even more problematic because the study found that “bond trading is concentrated in a very small subset of highly-liquid issues. This means that the vast majority of issues (with unique CUSIPs) do not even trade on a daily basis, creating a major challenge to best execution and pricing analytics.”

To help correct this, Bloomberg launched its BVal evaluated bond pricing product in late-2008. Today, BVal covers 2.5 million fixed income securities worldwide, including international, Euro, local, agency, munis, Treasury and emerging market bonds, including a bond pricing evaluation service to determine prices, especially in illiquid distressed securities.

According to Varun Pawar, global head of the Bloomberg Evaluated Pricing Service, these valuations use a transparent, three-step process that looks at variables, such as issuers and cash flows, and then calculates the spreads and prices to detect any “robust pricing” to help fix a bond’s price.

The actual price evaluation uses a two-step process that relies on data points based on past prices (validated bids and offers) and spreads. For illiquid securities, BVal looks at risk and cash flows to derive a yield based on a comparable bond.

“It is really, really important to have transparency for comparable bonds,” Pawar said.To derive an evaluated price, Varun says, BVAL’s models use available trades along with contributed dealer marks and other bond characteristics. This “triangulation” of available data produces a price that investment managers can rely on when they calculate the fund’s NAV. “In the illiquid space, it is very, very important to know how the relative value pricing model works and what comparable bonds are used to derive the price of the target illiquid security,” he said.


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