Is Your Bond Fund a Ticking Sub-Prime Time Bomb?

July 13, 2007

Investors buy bond funds because of their safety, but if your bond fund manager has taken significant positions in sketchy sub-prime bonds (the kind backed by questionable mortgage loans), your bond fund could be anything but. Worst case: as these sub-prime bonds continue to be downgraded by rating agencies, fund managers could be forced to unload them - which could lead to the bond fund equivalent of a good old-fashioned bank run:

Some funds have rules that require them to invest only in relatively safe bonds. So if bond credit rating firms lower ratings, pensions and mutual funds might have to sell large quantities of bonds. That can set off a dangerous spiral for mutual funds, (Morningstar bond analyst Lawrence Jones) said. If there is a rush to sell any security, the price can fall. And if mutual funds sell a large portion of their portfolio, the fund can take a loss. If investors then become jittery and want to bail out, the fund manager needs to come up with cash for investors. If the fund manager sells good securities to generate cash, more losses can occur."

The problem is it is very difficult to determine if your fund has significant sub-prime exposure until after the performance damage has been done. You can call the fund and ask, but they aren't required to reveal portfolio holding details, even to current investors.

Perhaps the best way to determine if something is fishy – as the article notes – is to check its performance during a rough patch for higher risk debt, like this past June. If your bond fund fell significantly more than a total bond index fund, figure out why (it could simply be a longer duration bond fund or an ordinary high yield bond fund) or throw in the towel.