Bond Funds Swimming Naked -- Page 2

An Everyday Disaster
Take the relatively modest example of  AIM Income . The fund tumbled 15.3% in 2008. That's the fund's worst performance since 1969, and in any other year that might have earned it a front-page story in The Wall Street Journal. But that wasn't anywhere near the worst bond fund showing. So explanations in the fund's fourth-quarter update about poorly performing mortgages and allocations to a suffering high-yield bond sector probably appear reasonable on the surface.

However, there's more to the story. The shareholder letter in AIM Income's July 2008 annual report gave at least one clue that the fund had taken on atypical risk, but then essentially dismissed it in the same breath. The letter noted that the fund "sold a credit protection swap to generate additional portfolio income," but also said that it maintained an overweight to the investment-grade corporate-bond market "by investing primarily in actual bonds." It may be that the fund actually sold only one new swap during the period, and there may be a legally defensible way to explain the meaning of "primarily," but eight pages after the "schedule of investments" there appears a list of 15 credit default swap contracts--every one of them generating long credit exposure--with a notional value of nearly $210 million. That number packs a punch given that the portfolio contained only $418 million in net assets at the time. In other words, those swaps didn't themselves add to the fund's interest-rate risk but made it roughly 150% exposed to credit- and mortgage-market movements not otherwise accounted for by interest-rate shifts.

Those exposures were more than halved by the end of October, so it's possible the fund's managers headed off even worse trouble, and they did benefit from a stake in long Treasury futures. The bottom line, though, is that the fund lost 10 full percentage points more than its average intermediate-term bond peer for the year.

You Ain't Seen Nothin' Yet...
There are numerous funds that endured more damage than AIM Income. Frankly, we were a little surprised to see  Putnam Income (PINCX) on the list. Putnam has found itself in the center of problems enough times in its history--both at the fund complex level and in its fixed-income group--to know better. Amazingly, though, this fund ultimately found itself exposed to levels of risk that, for a mutual fund of this type, can only be described as breathtaking.

Putnam's managers didn't look at it that way, though, because they were relying on historical data to target risk levels commensurate with the returns they were seeking, and those risk levels did not stand out to them. Yet, some portfolio digging turned up an alphabet soup of mortgage securities, many of which were potentially volatile derivatives, and the fund's schedule of investments reflected sector weightings that added up to nearly twice the fund's total net assets. (Subtracting around 20% in cashlike securities would imply roughly 180% in market exposure.)

That didn't create a sufficient level of risk to satisfy the fund's models. In addition to actual commercial mortgage-backed securities (CMBS), the fund also held a variety of off-balance-sheet total-return swaps. These had formed a truly massive exposure earlier in the year, but were fortunately reduced or allowed to expire before the sector imploded in 2008's fourth quarter. There were extremely large exposures to a menagerie of off-balance-sheet interest-rate and credit default swaps as well, both long and short. By the time the market was deep into its fall-season implosion, the fund's leverage had ballooned, and its total balance-sheet market exposure (cash-adjusted) was roughly 230% of its net assets at the end of October. The fund lost "only" 20.3% in 2008, which still left it more than 25 percentage points behind the Barclays Capital U.S. Aggregate Bond Index.

The Center of the Storm
Then there are those cases that approach catastrophe. We had been working on this issue when Oppenheimer's lead taxable-bond fund manager left suddenly, focusing our attention more squarely in that direction. We wrote about its foibles after Angelo Manioudakis' mid-December departure. As a result of the risks being taken among Oppenheimer's bond funds, 22--of the 25 in their lineup--lost more than 10% in 2008. At that time we focused on two of the most jarring losses,  Oppenheimer Core Bond  (OPIGX), which lost 36% for the year, and  Oppenheimer Champion Income  , a high-yield fund that plummeted an unthinkable 79%.

But although we weren't as surprised to see the firm's municipal-bond funds endure a terrible year, the magnitude of their losses can only be described as shocking. Manager Ron Fielding has always been known to us as a risk-taker, and the firm believes that its community of intermediaries and clients was well aware of that, too. All of his funds hold large stakes in bonds with ratings of BBB or lower, making them sensitive to movements in the municipal credit markets. In recent years, meanwhile, the funds have also been heavy owners of bonds backed by the states' tobacco master settlement agreement, one of the muni market's most volatile sectors, as well as so-called inverse floaters, which have leverage built into their structures.

Fielding has in the past criticized Morningstar severely for placing his national funds in our high-yield muni category, rightly noting that the BBB rated issues he favors are considered investment grade--not high-yield junk--and have historically had very few defaults. We insisted on keeping them in the high-yield muni group, though, given how the market typically treats and trades such bonds, and the volatility they have often engendered. Our concern has been that investors not confuse them with more conventional, lower-risk offerings. And in fairness, the Oppenheimer muni funds' shareholder materials have done an arguably much better job than most in terms of explaining risk. Still, a number of earlier shareholder letters gave mention to inverse floaters, for example, without going into much detail about their risks. We're not arguing here that Oppenheimer or any of the other firms actually violated any rules in their filings. Rather, in some cases it appears that while disclosure may have met regulatory hurdles, shareholder communications didn't do enough to tell fund owners what their risks might actually be.

Taken together, those risks turned out to be considerable. Fielding's two largest charges,  Rochester Fund Municipals  (RMUNX) and  Oppenheimer Rochester National Municipals (ORNAX), fell nearly 31% and 49%, respectively, in 2008. Those two funds alone recently accounted for more than half the assets under Fielding's command.

These are just some of the most notable fiascos. Unfortunately, we could go on and on.

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