20
It’s difficult to point to any one or two factors and
credibly argue that they alone make a bond fund bad.
One might be interpreted as a reason to sit up and
pay closer attention. If a bond fund flies multiple red
flags, though, chances are that it’s best left alone.
My Big Fat Yield
Tantalizing yields may actually portend trouble. By
most definitions, yield is a snapshot of how much
income a fund is paying out on an annualized basis,
relative to its net assets. The most important axiom
to remember, however, is that there is no free lunch.
Every source of return has some corresponding risk.
Sometimes it’s as obvious as big-time credit risk;
sometimes it’s as ephemeral as a dearth of liquidity.
And of course, those funds that yield the most often
attract a lot of attention. Try not to be sucked in.
Funds that get into the biggest trouble are often those
with the biggest yields. There’s a strong correlation
between how much yield that funds have offered and
how poorly they’ve performed during times of
market stress.
Concentration
In most cases, too much of a good thing is no different
from having all of your eggs in one proverbial basket.
When the markets blew up in
2008
, for example, a
number of funds had taken on very large exposures to
commercial mortgage-backed securities and paid a
heavy price for their aggressiveness. More recently, a
number of muni funds built up meaningful exposures
to Puerto Rico prior to the island’s debt selling off
sharply over the summer. The commonwealth had pre-
viously looked more creditworthy, but tolerating
concentration because of high ratings—such as those
earned by many subprime-mortgage tranches prior
to the financial crisis—has led to tears often enough.
Too Much Leverage
It was an article of faith in years past that open-end
mutual funds didn’t use leverage. Those years are
gone. It’s no reason to panic, but a lot of bond funds
use leverage these days. Most people think of lev-
erage as similar to margin borrowing. You start with
a portfolio, borrow money against it, and invest the
borrowed assets to boost your market exposure. The
key is that doing so will almost always magnify your
gains and losses, making your portfolio more volatile.
That’s not always bad, but the more leverage you
use, the more risk you take. There’s no rule that says
how much is too much, but once you get in excess
of
10%
–
15%
, it’s worth taking a hard look at what’s
going on. There are different ways for funds to develop
leverage, and it can be maddeningly difficult to find
it in fund reports. The best way to figure out if your
fund is leveraged is to ask. If your fund company can’t
provide a satisfactory answer, that’s its own red flag.
If there’s a unifying theme, it’s to avoid extremes. If
a fund purports to be of a certain ilk but actually looks
a lot different from its peers, that’s a red flag. The
chase for bond-fund assets is competitive, and it’s
tempting for managers to take on what may seem like
a marginal amount of risk in order to make their
wares look more attractive. For some, that temptation
is too strong—and disclosure too weak—leaving
investors saddled with funds that turn out to be much
riskier than they expected.
One More Thing: High Costs
When it comes to bond funds, high costs can be in-
sidious. Managers who have to cope with higher
expense ratios have added pressure because they
start the race behind everyone else. When you’re
already behind, it’s extremely tempting to take on
more risk just to keep up. And we’ve already
discussed where that temptation can lead.
œ
Contact Eric Jacobson at
How to Spot a Bad Bond Fund
Income Strategist
|
Eric Jacobson
