You may have encountered this yourself. When a firm goes into default on their bonds, the bondholders are left wondering if they'll ever see any money flow their way again. And at times, lawsuits are filed. Sometimes it takes years before a payment arrives. But when it does, how do you treat it?
First, do you treat it as an accrual? No, since there was no anticipation of any payment. Accruals should only be applied when there is a high degree of confidence or probability that a payment will be made. Once a bond goes into default, "all bets are off."
Second, is it income or a cash flow? Here, I think the answer is an "it depends." Technically, it's income. However, what if the bond was purchased by a prior asset manager, and your firm had no involvement in it at all. Because it's the same custodian, the income comes in and gets passed to you. For you to treat it as income would, I believe, be improper; for you, it's a cash flow. But if you were the manager who made the decision to purchase the bonds, then it's your income.
I hope this makes sense. Please comment if you have further thoughts or ideas you wish to share.
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Dave,
ReplyDeleteInteresting topic, but a couple of other thoughts to consider:
1) What if the portfolio receiving the class action has been reduced by 50% since the class action period? Treating as income in the current period could be distorting the return if the denominators are materially different.
2) What about the benchmark? If you treat it as income in the current period, is that period's return versus the benchmark really reflective of the investment manager's performance?
Do you credit the benchmark for the income as well, since it took the hit also, assuming it was an in-benchmark security? What if you over or underweighted the benchmark? And finally, what if the portfolio changed benchmarks after the class action period (you could argue you should get credit from a client perspective, but not from the composite perspective)?
In the end, it's probably little more than noise and isn't material, but if it's a significant class action settlement (Worldcom from a few years back, for instance), there may be more to think about.
Excellent points, and I'm sure other scenarios could come up which would make the inclusion as income look like a distorting effect. I guess the response is "and so what should we do instead?"
ReplyDeleteThe fact is that the portfolio has received income; much later than it should have, but it's finally here. For the past periods the account suffered a bit because it didn't have that income.
In addition, the firm could include explanatory language with its report to detail what happened and how it has affected the return.
If you can recommend another approach, that would be great. Thanks!
I agree that if you were the manager who made the decision to purchase the bond, then it's your income. But is it the composite’s income?
ReplyDeleteWhat about this non-fictional scenario? The bond was purchased by your firm in Account 1 when Account 1 was included in Composite 24. The bond and Account 1 suffered the largest loss while in Composite 24. A few days after the loss the assets from Account 1 transferred to Account 2 which happens to be in Composite 12. (Account 1 closed after the assets were transferred.) The bond was written-off while in Composite 12 and Account 2. At the time of the write-off the loss was not material for Composite 12 or Account 2. Then Account 2 changed strategies and moved to Composite 14. While Account 2 was included in Composite 14 a significant class action settlement was received.
Composite 24 now has a gap. Composite 12 is still active. Composite 14 is active.
Composite 24 actually suffered the bulk of the loss and should receive the benefit of the gain but there are no accounts in the composite. The composite could reopen in the future since the style is not considered closed.
What would you suggest for this scenario for a firm that claims GIPS compliance?