The three most denounced words in the investing vernacular these days are "mark to model." But let me clue you in on something.
Every bond portfolio is marked to model. Every mutual fund. Every UIT. Every brokerage account. Every portfolio manager. Every pension. Every hedge fund. Every bond portfolio in the whole damn world is marked to model.
"Wait a minute," you're probably thinking, "surely you jest! After all, you can't tell me that open-end mutual funds, which have to redeem shares at NAV on demand, can get away with mark to fantasy figures! Besides, they are mostly invested in more simple bonds, like Treasuries, agencies, corporates, munis, etc."
No, I don't jest. All those portfolios are marked to model. Consider the following:
- There are 152,732 different US dollar denominated corporate bonds outstanding as of today, according to Bloomberg.
- Between Fannie Mae, Freddie Mac, Federal Farm Credit Bank, and Federal Home Loan Bank, there are 21,989 different issues outstanding.
- There are 1,269,428 different municipal bond issues outstanding.
How many of those trade on a given day? A very small percentage. According to TRACE, which is a system for tracking corporate bond trading, about 4,300 TRACE eligible corporate issues trade each day. That's less than 3% of the total corporate universe. I note that trading activity in non-TRACE eligible bonds is not publicly reported. According to the MSRB, about 14,900
municipal bonds trade each day, or just over 1% of the universe.
Wait... It gets worse. Not only do a small percentage trade each day, but many don't trade at all for extended periods of time. Of the 4,300 bonds that trade each day, its often a few very liquid issues that trade over and over. Even many very large issues, for instance Washington Mutual 5.125 '15, which is a $1 billion issue, trade rarely. That bond has had only one trade of over $1 million during all of August.
So tell me how anyone can claim they've "marked to market" when a large percentage of their bonds have no recent trades. If there is no trade, there is no "market" price to use. And we know that using the last price wouldn't make sense. First of all, we know the general level of rates changes every day. Plus spreads move constantly as well. Again, take Washington Mutual. We know they are right in the middle of the sub-prime mess, so whatever you think of the company, you know the bonds are going to move significantly from day to day. So using a trade on August 16 to value the bond on August 31 makes no sense at all.
Some try to claim that getting dealer desks to value your portfolio is "marking to market" but let's think about the incentives for a moment. Bond dealer firms are sales organizations. They are run by sales people. They are not in the business of pissing their customers off by giving weak marks. So while many bond managers use dealer marks, it can be very dicey. I can say from first hand experience that sometimes sales people are all to happy to throw your ball back onto the fairway and assume you're OK with that.
So we're left with pricing matrices. These aren't perfect either. I have access to several matrices, and its not uncommon to find substantial differences from one model to another, even on relatively simple bonds. By virtue of the large variance in estimated prices, we know the models aren't perfectly reflecting reality.
Obviously there is a difference between an ABS CDO and a generic corporate. But as someone who deals with the reality of mark to model every day, I'm telling you, its no different. Only different in your mind. It's the difficulty to model CDOs that makes it problematic, not the concept of mark to model.