Why You Should Worry About Your Bond Funds

August 7, 2007

Today’s mutual fund investor is offered a broad range of choices covering every imaginable risk level - everything from essentially no-risk money market funds to leveraged sector short funds that can fall 10% or more in a single day.

As long as an investor understands the risks, investing in a risky fund in not inherently any better or worse than investing in a safe fund. With more risk comes more reward.
A risky fund tends to rise faster but fall harder. By researching a fund’s potential upside and downside an investor can make an informed decision whether or not they should invest in that fund.

It might be appropriate for a young person to build a portfolio with risky biotech and micro-cap funds, while a retiree looking for income would invest the majority of their money in lower risk bond funds. Either way, it’s vitally important that an investor can properly gauge a fund’s risk before they invest. Which is why what happened yesterday to the SSgA Yield Plus (SSYPX) is so troubling.

There are two main risks associated with investing in bonds: default risk (the risk a issuer will not make payments) and interest rate risk (the risk interest rates will rise making existing lower rate bonds less valuable). Bond fund managers reduce these risks by owning only investment grade bonds. Low duration bonds have less interest rate sensitivity because of either short maturities or adjustable rates. Investment grade bonds are those deemed very unlikely to default by the big bond rating agencies. The downside of such risk reduction is less upside in boom times for bonds.

The second safest fund category (right after money market funds which have a stable $1.00 fund price) is ultra short investment grade bond funds. People invest in ultra-short investment grade bonds when they don’t want to lose money – a short term place to park cash right before they are going to make a down payment on a house or before college tuition is due.

But on August 6th, 2007 SSgA Yield Plus, an ultra short bond fund holding investment grade bonds, fell a whopping 3.82%. This continues a fall that started on July 10th and has now taken this formally steady-as-she-goes fund down a sharp 6%.

Previous to this SSgA Yield Plus had been one of the top five lowest risk funds in the entire fund business over the last five years – out of a universe of nearly 7000 portfolios. We’ve used this fund ourselves as a money market alternative in both our MAXadvisor Powerfund Portfolios and our private management accounts.

We won’t know exactly what happened until one of the three fund managers returns our calls, but the fund company has confirmed it was not the result of a one-time distribution to clear the portfolio of capital gains. To quote one representative, it was “probably the way the market played today”.

Reviewing the portfolio shows the likely suspect: the entire portfolio is mortgage related securities. The problem is the mountains of mortgage related debt has now reached beyond the world of subprime, beyond the world of leveraged hedge funds, beyond the world of high risk mortgage lenders. It has landed squarely in one of the safest mutual funds in the business, and could have major ramifications for the entire stock, bond, and housing market as investors reallocate their money.

See Also:

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