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Fund Spy

Bond Funds Swimming Naked

The water receded in 2008 and some of what was revealed isn't pretty.

"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.

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Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.