Bond Funds Swimming Naked

Many of the bond mutual funds that posted losses in 2008 were hurt by the same crazy events that hit everyone else. But while manager after manager recites the same list of causes for his fund's painful losses, not all suffered the same level of decline. Usually, losses have been explained as untimely or wrongheaded sector calls. In a troubling turn, a number of mutual funds that made unusually concentrated or reckless sector bets borrowed money to create investment leverage, or have used derivatives in very speculative ways.

Eric Jacobson 05.03.2009
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"You only find out who is swimming naked when the tide goes out."--Warren Buffett

And you thought the hedge fund gunslingers were the problem.

Most investors would guess that bond mutual fund managers simply buy bonds and go home. The ones playing with fire--derivatives, leverage, swaps, and all that fancy stuff--were the hedge fund sharpies charging outrageous fees to exclusive clubs of multimillionaires, right? More than a few mutual fund managers shared that view.

It turns out, though, that many bond managers of the mutual fund variety don't have clean hands after all.

That's become clear thanks to the startling events of 2008. Sure, many of the bond mutual funds that posted losses in 2008 were hurt by the same crazy events that hit everyone else, namely the liquidity crisis and flight to quality that peaked in October and November. But while manager after manager recites the same list of causes for his fund's painful losses, not all suffered the same level of decline--not even close.

Even clipping off a tenth of the offerings at either of the extreme ends of the intermediate-term bond category (home to most "core" portfolios) leaves a 16-percentage-point range of returns from positive 5.6% to negative 10.7% for 2008. Usually, losses have been explained as untimely or wrongheaded sector calls. Many investment-grade funds favored the corporate credit of financial firms, for example, failing to anticipate how bad things would eventually get.

What happened? In a troubling turn, a number of mutual funds that made unusually concentrated or reckless sector bets borrowed money to create investment leverage, or have used derivatives in very speculative ways. In many cases, funds' terrible recent returns just haven't made sense in the context of readily available fund information or, in some cases, their managers' comments to analysts. After going much deeper into SEC filings, we've found levels of portfolio risk that, in some cases, we've rarely ever seen used in open-end mutual funds before. Often the managers involved had not distinguished themselves as risk managers to begin with.

Sifting through Mud
Once it became clear a few months ago that this was a widespread issue, our analysts began sifting through hundreds of portfolios, looking for signs that managers have been doing things about which they haven't been sufficiently candid. There are relatively simple tests that can be run to flag funds deserving of more attention. It's quite possible for two different approaches to look extremely similar, though: One fund may carry economic exposure to credit markets of twice its net assets, while the other does not when all of its offsetting exposures are properly recognized. Futures, interest-rate swaps, total-return swaps, credit default swaps, forward contracts, options, swaptions, and any number of other derivatives are typically buried in portfolio footnotes and endnotes, some of which are ambiguous at best, and useless at worst. A mere handful of those tools can alone alter the entire economic exposure of a portfolio.

But if a conventional, high-quality fund suffered double-digit losses in 2008, there's a reasonable chance that it did something atypically risky. After all, the Barclays U.S. Universal Bond Index returned 2.4% in 2008, and that isn't even a plain-vanilla benchmark. It holds nearly 10% in higher-volatility sectors, such as high-yield and foreign bonds; even if you strip out its hot-performing Treasury bonds, the Universal Bond Index would have suffered only a 0.92% loss. (Even though many taxable bond funds use the U.S. Aggregate Bond Index as a benchmark, they typically use exposures and take risk more in line with the Universal.)

In order to generate a loss of more than 10% a high-quality taxable fund would likely have been using leverage or derivatives of some type. Or it was making concentrated bets in sectors either lightly represented or completely absent from the common core indexes. With some exceptions, losing more than 10% has often meant poor portfolio diversification at best and a woeful disregard for the risks of concentration and leverage at worst.

That's a sobering thought. Roughly 120 distinct taxable bond funds, with total assets of nearly $150 billion at the start of 2008, lost more than 10% for the year. (To be clear: That doesn't even include generally more volatile world-bond, bank-loan, multisector, and high-yield portfolios.) In some ways it was an even rougher year for municipal-bond funds. One hundred and thirty-seven distinct funds lost more than 10% in 2008. Judging muni-fund risk-taking is a bit more involved than for taxable funds. That's because high-quality long-term munis themselves suffered immensely, and they're a staple of the muni universe. Still, given the staggering losses among funds of all risk appetites, there's reason to believe a number of them in each area took on more risk than shareholders expected.

An Everyday Disaster
Take the relatively modest example of AIM Income. The fund tumbled 15.3% in 2008. That's the fund's worst performance since 1969, and in any other year that might have earned it a front-page story in The Wall Street Journal. But that wasn't anywhere near the worst bond fund showing. So explanations in the fund's fourth-quarter update about poorly performing mortgages and allocations to a suffering high-yield bond sector probably appear reasonable on the surface.

However, there's more to the story. The shareholder letter in AIM Income's July 2008 annual report gave at least one clue that the fund had taken on atypical risk, but then essentially dismissed it in the same breath. The letter noted that the fund "sold a credit protection swap to generate additional portfolio income," but also said that it maintained an overweight to the investment-grade corporate-bond market "by investing primarily in actual bonds." It may be that the fund actually sold only one new swap during the period, and there may be a legally defensible way to explain the meaning of "primarily," but eight pages after the "schedule of investments" there appears a list of 15 credit default swap contracts--every one of them generating long credit exposure--with a notional value of nearly $210 million. That number packs a punch given that the portfolio contained only $418 million in net assets at the time. In other words, those swaps didn't themselves add to the fund's interest-rate risk but made it roughly 150% exposed to credit- and mortgage-market movements not otherwise accounted for by interest-rate shifts.

Those exposures were more than halved by the end of October, so it's possible the fund's managers headed off even worse trouble, and they did benefit from a stake in long Treasury futures. The bottom line, though, is that the fund lost 10 full percentage points more than its average intermediate-term bond peer for the year.

You Ain't Seen Nothin' Yet...
There are numerous funds that endured more damage than AIM Income. Frankly, we were a little surprised to see Putnam Income on the list. Putnam has found itself in the center of problems enough times in its history--both at the fund complex level and in its fixed-income group--to know better. Amazingly, though, this fund ultimately found itself exposed to levels of risk that, for a mutual fund of this type, can only be described as breathtaking.

Putnam's managers didn't look at it that way, though, because they were relying on historical data to target risk levels commensurate with the returns they were seeking, and those risk levels did not stand out to them. Yet, some portfolio digging turned up an alphabet soup of mortgage securities, many of which were potentially volatile derivatives, and the fund's schedule of investments reflected sector weightings that added up to nearly twice the fund's total net assets. (Subtracting around 20% in cashlike securities would imply roughly 180% in market exposure.)

That didn't create a sufficient level of risk to satisfy the fund's models. In addition to actual commercial mortgage-backed securities (CMBS), the fund also held a variety of off-balance-sheet total-return swaps. These had formed a truly massive exposure earlier in the year, but were fortunately reduced or allowed to expire before the sector imploded in 2008's fourth quarter. There were extremely large exposures to a menagerie of off-balance-sheet interest-rate and credit default swaps as well, both long and short. By the time the market was deep into its fall-season implosion, the fund's leverage had ballooned, and its total balance-sheet market exposure (cash-adjusted) was roughly 230% of its net assets at the end of October. The fund lost "only" 20.3% in 2008, which still left it more than 25 percentage points behind the Barclays Capital U.S. Aggregate Bond Index.

The Center of the Storm
Then there are those cases that approach catastrophe. We had been working on this issue when Oppenheimer's lead taxable-bond fund manager left suddenly, focusing our attention more squarely in that direction. We wrote about its foibles after Angelo Manioudakis' mid-December departure. As a result of the risks being taken among Oppenheimer's bond funds, 22--of the 25 in their lineup--lost more than 10% in 2008. At that time we focused on two of the most jarring losses, Oppenheimer Core Bond, which lost 36% for the year, and Oppenheimer Champion Income, a high-yield fund that plummeted an unthinkable 79%.

But although we weren't as surprised to see the firm's municipal-bond funds endure a terrible year, the magnitude of their losses can only be described as shocking. Manager Ron Fielding has always been known to us as a risk-taker, and the firm believes that its community of intermediaries and clients was well aware of that, too. All of his funds hold large stakes in bonds with ratings of BBB or lower, making them sensitive to movements in the municipal credit markets. In recent years, meanwhile, the funds have also been heavy owners of bonds backed by the states' tobacco master settlement agreement, one of the muni market's most volatile sectors, as well as so-called inverse floaters, which have leverage built into their structures.

Fielding has in the past criticized Morningstar severely for placing his national funds in our high-yield muni category, rightly noting that the BBB rated issues he favors are considered investment grade--not high-yield junk--and have historically had very few defaults. We insisted on keeping them in the high-yield muni group, though, given how the market typically treats and trades such bonds, and the volatility they have often engendered. Our concern has been that investors not confuse them with more conventional, lower-risk offerings. And in fairness, the Oppenheimer muni funds' shareholder materials have done an arguably much better job than most in terms of explaining risk. Still, a number of earlier shareholder letters gave mention to inverse floaters, for example, without going into much detail about their risks. We're not arguing here that Oppenheimer or any of the other firms actually violated any rules in their filings. Rather, in some cases it appears that while disclosure may have met regulatory hurdles, shareholder communications didn't do enough to tell fund owners what their risks might actually be.

Taken together, those risks turned out to be considerable. Fielding's two largest charges, Rochester Fund Municipals and Oppenheimer Rochester National Municipals fell nearly 31% and 49%, respectively, in 2008. Those two funds alone recently accounted for more than half the assets under Fielding's command.

These are just some of the most notable fiascos. Unfortunately, we could go on and on.

Silence of the Wolves
This combination of outsized risks, a dearth of more candid shareholder communication, and, in several cases, a failure to discuss relevant issues with analysts, is troubling to say the least. And it has happened at numerous firms. Although we regularly and systematically examine the data provided by fund firms, we've long had to rely on the candor of bond managers to effectively decipher their strategies, tactics, and overall portfolio exposures. Unlike equity mutual fund portfolios, analyzing and measuring security-level and portfolio information has always been maddeningly complex on the bond side. Even in the case of relatively simple bond portfolios, it can be tricky to draw too many conclusions about the information one cobbles together from portfolio disclosures. We therefore expect that our analysts' interviews with fund managers will fill in many of the gaps. And frankly, we expect that unquestionably material fund characteristics such as leverage will be brought up--loud and clear--in response to simple questions like "Is there anything else about your portfolio that you think is important for us to know?" Too often, they weren't.

A Stunning Failure of Stewardship
The breadth and depth of these informational omissions is nothing short of astounding. It's a sad turn of events for the industry, which has been a leader in transparency when compared with many others.

A number of managers simply made poor decisions at a sector level. And there are reasons it's difficult to discern among the forces of deliberate intent, benign neglect, and poor judgment when it comes to the decisions that they made. Make no mistake, though: A considerable number of managers and fund companies appear to have badly failed their investors in terms of both basic management and stewardship.

That's All Well and Good for Sheep
What should you do if you're concerned about your own fund? If you're a Morningstar Premium Member, check to see whether our Analyst Reports have highlighted risks of this type. (We have already shared warnings about risk in many cases, even if fund companies hadn't disclosed greater detail to us during our regular interviews.) Then look through your annual or semiannual shareholder reports. If you've thrown them out, don't worry. The most recent reports are almost always available for free on fund company Web sites, or from our fund quote pages on under the left-side tab marked "SEC Filings." If you want to look back even further, you should be able to track down older filings at the SEC's EDGAR Web site.

It may not interest you to read these in great detail. As far as we're concerned, though, anything in a fund's portfolio that isn't adequately explained in its reports is a shortcoming. In particular, if you find scads of the aforementioned derivatives, such as inverse floaters and swaps, whose use and performance aren't clearly explained, we would suggest picking up the phone and calling your fund company. Many representatives won't be trained in the finer points of these securities, but there should be someone at every firm who can help you understand more about how much risk your fund is or isn't taking. If you use a financial intermediary such as a broker or fee-based planner, that person may be able to help you navigate the fund-company waters and get answers to your questions.

What we've found here is especially disappointing given the great strides bond fund managers have made in the past 20 years. Once the domain of run-and-gun hotshots who made big bets in an effort to juice portfolio yields and seize the interest of salespeople, the universe of so-called "retail" bond funds sold to individual investors has become increasingly reflective and thoughtful, adopting many of the institutional world's best practices.

Unfortunately, it looks as though in many such cases managers found themselves emulating the sophisticated tools and strategies of the industry's marquee names, without sharing those players' comprehensive understanding of risk--or their skills.

Mutual fund analyst Miriam Sjoblom contributed to this article.

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Eric Jacobson  Eric Jacobson is a Senior Fund Analyst on the active funds research team with Morningstar.

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