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How to Spot a Bad Bond Fund Income Strategist | Eric Jacobson

Too Much Leverage It was an article of faith in years past that open-end mutual funds didn’t use leverage. Those years are gone. It’s no reason to panic, but a lot of bond funds use leverage these days. Most people think of lev- erage as similar to margin borrowing. You start with a portfolio, borrow money against it, and invest the borrowed assets to boost your market exposure. The key is that doing so will almost always magnify your gains and losses, making your portfolio more volatile. That’s not always bad, but the more leverage you use, the more risk you take. There’s no rule that says how much is too much, but once you get in excess of 10% – 15% , it’s worth taking a hard look at what’s going on. There are different ways for funds to develop leverage, and it can be maddeningly difficult to find it in fund reports. The best way to figure out if your fund is leveraged is to ask. If your fund company can’t provide a satisfactory answer, that’s its own red flag. If there’s a unifying theme, it’s to avoid extremes. If a fund purports to be of a certain ilk but actually looks a lot different from its peers, that’s a red flag. The chase for bond-fund assets is competitive, and it’s tempting for managers to take on what may seem like a marginal amount of risk in order to make their wares look more attractive. For some, that temptation is too strong—and disclosure too weak—leaving investors saddled with funds that turn out to be much riskier than they expected. One More Thing: High Costs When it comes to bond funds, high costs can be in- sidious. Managers who have to cope with higher expense ratios have added pressure because they start the race behind everyone else. When you’re already behind, it’s extremely tempting to take on more risk just to keep up. And we’ve already discussed where that temptation can lead. œ Contact Eric Jacobson at eric.jacobson@morningstar.com

It’s difficult to point to any one or two factors and credibly argue that they alone make a bond fund bad. One might be interpreted as a reason to sit up and pay closer attention. If a bond fund flies multiple red flags, though, chances are that it’s best left alone. My Big Fat Yield Tantalizing yields may actually portend trouble. By most definitions, yield is a snapshot of how much income a fund is paying out on an annualized basis, relative to its net assets. The most important axiom to remember, however, is that there is no free lunch. Every source of return has some corresponding risk. Sometimes it’s as obvious as big-time credit risk; sometimes it’s as ephemeral as a dearth of liquidity. And of course, those funds that yield the most often attract a lot of attention. Try not to be sucked in. Funds that get into the biggest trouble are often those with the biggest yields. There’s a strong correlation between how much yield that funds have offered and how poorly they’ve performed during times of market stress. Concentration In most cases, too much of a good thing is no different from having all of your eggs in one proverbial basket. When the markets blew up in 2008 , for example, a number of funds had taken on very large exposures to commercial mortgage-backed securities and paid a heavy price for their aggressiveness. More recently, a number of muni funds built up meaningful exposures to Puerto Rico prior to the island’s debt selling off sharply over the summer. The commonwealth had pre- viously looked more creditworthy, but tolerating concentration because of high ratings—such as those earned by many subprime-mortgage tranches prior to the financial crisis—has led to tears often enough.