How Misleading Maturities Make Bond Funds Riskier
In 2008, many short-term bond funds experienced large losses, far greater than investors expected given the short duration of the funds and the fact that there was not a large increase in actual defaults. How did this happen? In some cases, the stated maturities of funds were misleading.
Geng Deng, Craig McCann and Edward O'Neal sought to determine how these losses occurred in their study "What Does a Mutual Fund's Term Tell Investors?" Previously, the authors had demonstrated how the use of average credit quality understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. The average credit rating doesn't account for the fact that credit risk increases geometrically. This new study found a similar problem caused by how a fund determines average maturity.
The problem arises when a short-term bond fund seeks to increase yield by purchasing either floating-rate notes or the long-term debt of lower-rated credits and using interest rate swaps to shorten their exposure to term risk, but not credit risk. Since credit risk increases with the horizon, the fund then reports higher yields without showing longer maturities (misleading investors). In other words, a BBB-rated 30-year floating-rate note, with interest rates resetting every three months based on three-month Libor, doesn't have the same risk profile as a three-month security from the same issuer. That's why the longer-term note will have a higher yield. It's not a free lunch. 2008 provided investors with a painful reminder that it's often a long way from yield to return.
Because of the potential for mischief, investors who relied on either a fund's reporting of term risk or Morningstar's classification were making decisions without the full information needed to judge the risks. As an example, Morningstar might classify a fund as ultra short, yet the fund could own securities with 30 years of credit risk. The large losses reported in 2008 were caused by widening credit spreads and increased premiums for less liquid assets.
The authors provided the following example of how a fund misled investors. The Schwab YieldPlus Fund (SWYSX) stated in its 2007 annual report that about 60 percent of the securities in the portfolio matured within six months. Yet, as of the date the report was released, less than 2 percent of the market value of SWYSX's securities matured within six months. Schwab used the next coupon date as the maturity date for the vast majority of these securities, even for 30-year and 40-year bonds. In 2006 and 2007, the true weighted average maturity was between 25 and 30 years.
On its Web site, the SEC says ultra-short bond funds generally invest in fixed income securities with extremely short maturities or time periods in which they become due for payment. However, the authors found that the average maturity of the 43 funds classified by Morningstar as "ultra short term" in early 2008 ranged from 1.8 years to 27.6 years, and more than half the funds had average maturities greater than 20 years. "The mutual fund industry's use of this category designation is clearly inconsistent with the SEC's statement to investors."
Returns To show the damage that could be done, the authors looked at 36 retail ultra short bond funds from January 1, 2008 to December 31, 2008. They found that the average return was -7.0 percent, and six funds lost more than 20 percent. The losses occurred despite no coinciding widespread defaults. Thus, losses should have been essentially non-existent as the short-term bonds matured and were redeemed at par. (Any losses as a result of mark-to-market would have been very short term.)
When interest rates were at similarly low levels to what we're now facing, my firm was being asked (pressured) by clients about switching their short-term bond holdings to the aforementioned SWYSX. Before approving any fund, we take a careful look "under the hood." Based on our findings, we wouldn't approve the fund. Unfortunately, very few individual investors have the knowledge or awareness or access to dig into a fund's individual holdings. Thus, they were left to rely on Morningstar's rating, which misled them. The extraordinary credit risk resulting from a fund holding long-term, non-government securities caused the funds to predictably suffer large losses when credit spreads widened in 2008.
This tale provides another reminder that the main role of fixed income in a portfolio is to dampen the risk of the overall portfolio to an acceptable level. Taking risk, be it term or credit, isn't the prudent strategy.
Photo courtesy of Horia Varlan on Flickr.
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