By: Robert Gordon
By: Robert J. Gordon, CFP®, AIF®
Towards the end of 2007, many investors, fearful of equity market volatility, sought refuge in short and so-called ultrashort bond funds. The word short here refers to the bond’s duration which is a measure of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. Generally speaking, bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.1 They figured, “sure the yields are relatively low in this group of investments but so is the risk”. That was an unfortunate mistake. Drawn in by attractive titles and descriptions some investors even mistakenly equated these mutual funds with money market mutual funds. While the titles may convey a message of low risk and stability, the reality turned out to be very different.
By now, everyone is familiar with the subprime mortgage crisis and the dramatic effect it has had on both domestic and international economies. Its tentacles have spread far and wide and, unfortunately, its effects have popped up in many unexpected places. Ultra short term bond funds typically invest in AAA-rated bonds with maturities of 2 years or less. Their returns have generally kept pace with inflation with relatively low volatility. A good example might be the State Street Global Advisor YieldPlus which registered a better than 4% annualized return from 1992 through the end of 2006 with a standard deviation of a bit more than ½%. However, 2007 was the year when the market began to feel the cumulative effects of the frothy real estate market. As a category, ultra short bonds, registered their worst annual performance last year, down 1.6% overall. This year, 2008, is shaping up to be just as challenging for the category with an overall negative 1.9% performance for the first quarter. The aforementioned State Street Global Advisors YieldPlus is down over 30% for 2008 so far. What gives? Subprime strikes again!
In an effort to garner a little extra return, some managers of ultrashort funds invested in mortgage-backed securities. Generally, the ultra short funds that are suffering the most are those with the highest percentage of their total portfolio in mortgage-backed securities. Funds which opted to forego the seemingly attractive returns of mortgage-backed securities fared much better. Dimensional Fund Advisors, a firm whose mantra is that the role of bonds in a portfolio is to dampen the volatility of equities, sponsors the DFA One Year Fixed Income fund which turned in a positive 5.19% return in 2007.
How could the average investor have avoided this pitfall? Doing your homework might not have helped, especially if you relied on materials produced by the fund sponsors. Schwab’s online brochure for their YieldPlus fund reads,
“The Schwab YieldPlus® is designed with your income needs in mind. The fund’s objective is to seek high current income with minimal changes in share prices.”
It sounds great but the chart which accompanies that description in the same brochure shows a 1 year performance of negative 21%! That is more than just a minimal change in share price! This performance is particularly alarming and misleading when, in the same brochure, the fund’s performance is compared to the Lehman Brothers U.S. Treasury: 9-12 month Index. The index shows a positive 6.73% 1-year performance. While the fund did hold securities of the type mentioned in the index, those were not the only investments they held. In all fairness, despite the initial verbiage, throughout the online brochure it reads, “YieldPlus is an ultra-short bond fund and not a money market fund and should not be considered as a substitute for a money market fund.” One would hope that this verbiage was present from the beginning and not added in response to the market malaise.
Greed Is Not Necessarily Good
It was no doubt greed not naivet © that caused money managers to take such substantial risks on these securities. Typically, securities of similar risk and return characteristics receive similar ratings and are priced similarly in the marketplace. Bob Auwaerter, head of the bond investment team for Vanguard funds, surmises that “a lot of fund managers got used to taking chances to stretch for yield and forgot to question why a triple-A rated mortgagebacked security would be quoted at a yield nearly a full percentage point more that other triple-A debt.” In other words, if the securities were the same in terms of expected risk and return, why would the issuer pay so much more, in terms of interest rate, to attract investors. Perhaps some blame can be placed on the ratings agencies for not being more meticulous in their ratings or for not having classifications that sufficiently differentiate between securities. Combine these shortcomings with a very impatient investing audience and you have the makings of an investment catastrophe.
Stick To The Basics
Those who moved money into these funds over the last year or so are no doubt surprised and frustrated, not to mention poorer. Because the normal risk-adjusted return of this particular group of investments is relatively low, it is unlikely that they will recover their capital in the near term. When it comes to fixed income investing, it is important to remember its role in an investment portfolio – to reduce volatility. Someone once said, “Bonds are boring”. The appropriate response to that should be, “Fine!”
1 http://www.investopedia.com/ section entitled “Advanced Bond Concepts: Duration”