Morningstar Advisor - April/May 2009 - 32

Spotlight Where Leverage Lurks By Eric Jacobson Use of leverage was widespread among bond funds in 2008, and shareholders had few ways of knowing. “You only find out who is swimming naked when the tide goes out.” —Warren Buffett And you thought the hedge-fund gunslingers were the problem. Most investors would guess that managers of fixed-income mutual funds simply buy bonds and go home. The ones playing with fire— derivatives, leverage, swaps, and all that fancy stuff—were the hedge-fund sharpies charging outrageous fees to exclusive clubs of multimillionaires, right? It turns out, however, that many mutual-fund bond managers don’t have clean hands after all. That’s become clear thanks to the startling events of 2008. To be sure, many of the bond mutual funds that posted losses in 2008 were hurt by the same crazy events that hit everyone else, namely the liquidity crisis and flight to quality that peaked in October and November. Some of the losses can be explained as untimely, or wrongheaded, sector calls. Many investment-grade funds, for example, favored the corporate credit of financial firms, failing to anticipate how bad things would eventually get. But while manager after manager recites the same list of causes for his or her fund’s painful losses, the dispersion of returns among bond funds in the same categories was wide in 2008. Even clipping off a tenth of the offerings at either of the extreme ends of the intermediate-term bond category (home to most “core” portfolios) leaves a wide 16-percentage-point range of returns, from positive 5.6% to negative 10.7%. What gives? We have uncovered a number of fixed-income mutual funds that made unusually concentrated or reckless sector bets, borrowed money to create investment leverage, or have used derivatives in very speculative ways. In many cases, funds’ terrible returns just haven’t made sense in the context of readily available fund information or their managers’ comments to analysts. After going much deeper into SEC filings, we’ve found levels of portfolio risk that we’ve rarely ever seen used before in open-end mutual funds. Sifting through Mud After all, the Barclays U.S. Universal Bond Index returned 2.4% in 2008, and that isn’t even a plain-vanilla benchmark. It holds nearly 10% in sectors more volatile than most, such as high-yield and foreign bonds. Even if you strip out its hot-performing Treasury bonds, the Universal Bond Index would have suffered only a 0.92% loss. To generate a double-digit loss of more than 10%, a high-quality fund likely used leverage or derivatives of some type. Or it made concentrated bets in sectors either lightly represented or completely absent from the common core indexes. With some exceptions, losing more than 10% in 2008 meant poor portfolio diversification at best and a woeful disregard for the risks of concentration and leverage at worst. That’s a sobering thought. Roughly 120 distinct taxable-bond funds, with total assets of nearly $150 billion at the start of 2008, lost more than 10% for the year. (This figure doesn’t even include the more volatile world-bond, bank-loan, multisector, and high-yield portfolios.) In some ways, 2008 was an even rougher year for municipal-bond funds: 137 distinct muni-bond funds lost more than 10%. Judging muni-fund risk-taking is a bit more involved than for taxable funds. That’s because high-quality long-term munis themselves suffered immensely, and they’re a staple of the muni universe. Still, given the staggering losses among funds of all risk Once it became clear a few months ago that the use of leverage was widespread, Morningstar analysts began sifting through hundreds of portfolios, looking for signs that managers have been doing things about which they haven’t been candid. We didn’t like what we uncovered. If a conventional, high-quality bond fund lost more than 10% in 2008, there’s a reasonable chance that it did something atypically risky. 32 Morningstar Advisor April/May 2009

Morningstar Advisor - April/May 2009

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