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April's Mutual Fund Red Flags

Bond funds at risk.

Lawrence Jones, 04/17/2007

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

The past few years have seen some fairly smooth sailing for many parts of the fixed-income marketplace, and indeed some bond-fund categories, such as emerging markets and high yield, have enjoyed sustained bull markets. Markets have benefited from historically low default rates, a reasonably transparent Federal Reserve rate-hiking cycle (on hold since June), and significantly improved corporate balance sheets.

However, a long-running rally typically leaves funds more vulnerable to certain risks. The following funds have been chosen to illustrate one aspect of risk in the fixed-income markets. We will look at credit risk, event risk, and interest-rate risk, each in turn.

Fidelity Capital & Income FAGIX
This fund's manager, Mark Notkin, takes on significant credit risk here. With 42% of fund assets recently rated B or below (including nonrated issues), trouble could result should defaults spike with a slowdown in the economy. (Moody's, the bond-rating agency, expects the default rate to double in the next year to 3.2%.) Fortunately for Notkin, and other high-yield investors, default rates have been at near-record lows (currently near 1.6%). In fact, the month of February actually saw no below investment-grade defaults, a situation not seen in a decade. That said, Notkin has already been sensibly dialing down the fund's credit risk by shifting assets into bank loans, which are higher in the capital structure than bonds, and by paring back the portfolio's exposure to subordinated issues, which are less secure than senior debt.

Vanguard Long-Term Investment-Grade VWESX
This fund carries some credit risk and a sizable degree of interest-rate risk. But with the default rate still low and the Federal Reserve on hold, what most concerns veteran manager Earl McEvoy right now is event risk. And more specifically, leverage buyout risk, which has increased greatly over the past couple of years. While buyouts can often be good news for equity funds, they are typically bad for bondholders, and particularly for funds that traffic heavily in the corporate sector, like this one does. That is because the additional leverage used to finance a deal can impair the company's ability to repay its obligations. Also, the credit quality of the company can deteriorate, resulting in higher borrowing costs.

To protect the fund somewhat from this, McEvoy has shifted some fund assets from the corporate sector to taxable municipals, agency debt, and foreign-sovereign issues. Additionally, certain areas of the corporate market, such as banking, finance, and utilities can offer some protection, though in the current frenzied LBO environment, few companies seem to be offlimits. So, while we're encouraged with McEvoy's defensive moves here, the risk of an LBO event, or even the impact of a large LBO on investor sentiment, could be a concern for corporate-bond-focused funds.

T. Rowe Price U.S. Treasury Long Term PRULX
The Fed has paused its most recent rate-hiking cycle after stair-stepping its overnight bank-lending rate, the federal-funds rate, from 1% in June 2004 to 5.25% in late June 2006. This matters for manager Brian Brennan, who typically keeps the fund's duration (a measure of interest-rate sensitivity) within a range of nine to 11 years, because bonds the fund holds can see price declines as rates rise.

That said, in recent years the fund has been more defensively positioned than some long-term government-category rivals, so it has fared better during the recent hiking cycle. The fund's recent duration of 10.6 years can be seen to roughly indicate that the average price of a bond in the portfolio will rise or fall by 10.6% for every 1% change in rates. This could be a significant challenge for investors, because there is a great deal of uncertainty in the market regarding not only the timing of the next rate change, but also the direction of change.

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