Gjergji Cici, Pei (Alex) Zhang
Review of Finance, Volume 28, Issue 6, November 2024, Pages 2017–2049, https://doi.org/10.1093/rof/rfae028
The corporate bond market is larger, more illiquid, and presumably less efficient than the equity market. These features provide numerous profit opportunities for active corporate bond mutual funds that are unique to the corporate bond market. However, whether active corporate bond mutual funds have the valuation skills needed to take advantage of these opportunities is unclear. We develop a novel measure to identify investment-grade corporate bond funds with superior valuation skills. Our measure, which we refer to as the valuation accuracy score, recognizes funds holding more underpriced and less overpriced corporate bonds as ex-ante having better valuation skills. Key to the construction of the valuation accuracy score is a unique feature of the corporate bond market that many firms have multiple bonds outstanding, which we exploit to identify mispriced bonds.
We find that the valuation accuracy score has strong predictive power for future fund performance, an effect that materializes through superior bond selection. This result is economically and statistically significant and robust to several methodological choices. In addition, the valuation accuracy score of corporate bond mutual funds is highly persistent over time and unrelated to other sources of skill. Taken together, these findings suggest that our measure reflects a type of skill that is stable over time and unique in relation to other possible sources of skill. Fund investors seem to recognize the differential valuation skills of investment grade bond fund managers: they consider good past performance of funds with higher valuation accuracy scores an even stronger indicator of skill, while they become less sensitive to poor performance relative to good performance of these funds. The findings of our paper taken together contribute to the larger debate on the investment abilities of corporate bond funds, further our understanding of the types of skills that these funds possess and help us understand how investors respond to performance of skilled corporate bond mutual funds.