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The Subprime Mess and Your Portfolio, Part 2

Which funds have been hurt the worst by subprime woes?

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The biggest financial story of 2007 has undoubtedly been the subprime-mortgage crisis and its increasingly widespread fallout. The first rumblings of the problem started last year, then the crisis exploded in February and March of this year as defaults spiked in subprime mortgages and mortgage lenders such as New Century Financial started going bankrupt. Since then, the situation has only continued to get worse, and the crisis has spread throughout the financial world, ensnaring such Wall Street heavyweights as  Citigroup (C),  Merrill Lynch & Company  (MER), and  Goldman Sachs (GS).

Back in early May, we took a look at the effect of the subprime crisis on mutual funds up to that point, and we suggested some ways for fund investors to judge how their portfolio might be affected. At the time, few people had any idea how bad things would get, and there have been a lot of new developments in the past seven months. We've written about many of these specific developments already, but we thought it would be a good idea to take another broad look at the impact of the crisis on mutual funds, including how things have changed since May and what you can do now.

The Effect on Bond Funds
The subprime meltdown has had a significant effect on many bond funds. Most mortgages in the U.S., including subprime ones, get packaged into bonds and sold to investors through mortgage-backed securities and asset-backed securities. In theory, at least, investors can choose how much risk they want to take on, from very safe, AAA rated mortgage-backed securities down to much riskier, lower-rated asset-backed securities based on subprime mortgages. In practice, it hasn't been quite that simple. As the effects of the crisis have spread, bond-rating agencies such as Standard & Poor's and Moody's have downgraded increasing numbers of formerly high-rated securities after it became apparent that they had more subprime exposure than previously thought. That, in turn, has caused pain for some bond funds, including some you wouldn't necessarily expect.

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.