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Your government fund may hold hidden risk
The SECs concern about what government bond funds actually hold is a yellow flag that hides a red flag, which is the vulnerability of Treasurys and mortgage-related bonds to rising interest rates.
By Timothy Middleton
The Securities and Exchange Commission fired a broadside into the mutual fund mess last week, admonishing "government" bond funds to be more forthright in acknowledging the risks they take, notably by investing in mortgage-backed securities.
It wasnt a seismic announcement of scandal like the one lobbed last month by New Yorks attorney general. But it was a worthwhile reminder that funds have to be dragged kicking and screaming into public disclosure of even the most basic portfolio attributes.
It's also important because the portfolio attributes of these bond funds could be seismic over the next year or two. Even Treasury Secretary John Snow has acknowledged that interest rates will head up as the economy expands, which in turn would push bonds around. Some bond gurus are more specific.
Next spring -- March, April or May -- the Federal Reserve is going to start raising the Federal Funds rate, says Tom Atteberry, co-manager of FPA New Income Fund (FPNIX). That is the Federal Reserve's overnight borrowing rate, currently 1%.
The SEC said that funds need to let investors know that they may hold mortgage-related bonds even when their fund names make it sound like they own only U.S. government bonds. The concern is that some investors might believe "government" means Treasury bonds, which are fully backed by the government.
Prodded by Morningstar
In fact, many of these funds own mortgage bonds from companies such as Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), which are government-sponsored entities whose debt isn't guaranteed by the Treasury. The market often treats them as if they were fully backed by the government because they have multi-billion dollar credit lines with the Treasury.
The SEC acted in response to research by Morningstar, which found that more than 180 bond funds held at least one-third of their assets in Fannie and Freddie debt, although their names didnt include mortgage or otherwise acknowledge the link.
Ultraconservative investors want funds that invest strictly in Government National Mortgage Association bonds, called Ginnie Maes, which are backed by the full faith and credit of the federal government. Many mutual fund companies issue such carefully tailored portfolios.
For instance, Pimco GNMA Fund (PDMIX) differs from Pimco Total Return Mortgage Fund (PTRIX) chiefly in that the former invests strictly in guaranteed paper and the latter in Fannies and Freddies.
Check up on your fund
Treasurys and mortgage bonds are hypersensitive to interest rates. Treasury bonds, bills and notes have no other risk factored into their price and so are most sensitive to rate changes. Mortgage bonds are ultra-sensitive because of a perverse characteristic called negative convexity.
For most investors, therefore, the SECs concern is a yellow flag that hides a red flag, which is the vulnerability of these bonds, especially mortgages, to rising interest rates.
So while these bonds should make up the core of any fixed-income investors portfolio, they'll require careful management in coming months to rein in risks. Fund companies dont necessarily make this easy to do, but I'll recommend a strategy that does it for you.
The first task is to untangle the web that mutual funds spin to make their portfolios sound safer than they are. The SEC charges that in many instances the special risks of mortgage bonds are relegated to footnotes in a funds prospectus or to a document called the Statement of Additional Information that few investors ever read.
If you own a government fund, its time to read these two important documents. If you dont have them in your files, you can read them at the SECs surprisingly good Web site, which provides better access to the agencys Edgar database than some private services I've used. (See link at left under Related Sites.)
Understanding the risks
But even full disclosure wont protect you from one issue unless you already understand the unusual nature of mortgage bonds issued by Fannie Mae and Freddie Mac. Fannies and Freddies, though they are only quasi-governmental, are the mainstay of the typical "government bond" fund because they yield one to two percentage points more in interest than plain-vanilla Treasurys.
Massachusetts Financial Services, which sponsors the MFS Government Securities Fund (MFGSX), does say that its fund invests in more than Treasurys, writing in the opening paragraph of the funds fact sheet: Management seeks to drive performance through sector rotation among various government securities, including: U.S. Treasurys, Ginnie Maes, Freddie Macs, Fannie Maes, Sallie Maes and other U.S. agencies and instrumentalities.
Chris Mahony, the manager of Seligman U.S. Government Securities Fund (SUSGX), has 70% of his $160 million of assets in mortgage-backed securities, nearly all of them issued by Ginnie Mae, true full-faith-and-credit bonds.
Seligman is a very conservative investment house, and Mahonys mortgage bonds aren't mortgage pass-throughs, which are the most dangerous kind now. Rather, they're collateralized mortgage obligations, or CMOs. These are tightly bundled loans that mature within as few as 18 months. Short maturities are a strong defense against rising rates, because they have the least interest-rate sensitivity.
Pass-throughs, which most funds own, have indeterminate maturities strongly tied to current interest rates, which produce a characteristic economists call negative convexity. Mahony defines the term this way: Negative convexity is the propensity of a bond to do exactly what you dont want it to do under every interest-rate scenario.
Limiting volatility
When rates are rising, investors shorten the average maturity of their portfolios to reduce interest-rate risk. Mortgage bonds, however, lengthen in maturity as rates rise, because refinancings disappear and mortgage origination slows.
When rates are falling, investors lengthen maturities to capture more yield. The maturity of mortgage bonds, though, automatically shortens as refinancings increase. Investors get their money back when they least want it, with new rates lower than those they were already earning.
Managers such as Mahony take steps to limit these risks, but their hands are tied by their mandates to remain in government paper. For this reason, I recommend fixed-income investors buy diversified intermediate-term bond funds, such as FPA New Income or Pimco Total Return (PTTRX), the nations largest actively managed mutual fund.
Funds with intermediate maturities deliver returns that average 85% of those of long-term funds but with considerably less short-term volatility. Long bond funds take the most interest-rate risk, and are particularly bad bets now.
Staying away from Freddie
William Blair Income Fund (WBRRX), a short-maturity portfolio, has less than 40% of its assets in Treasurys and mortgages. The majority of assets are spread over corporate and asset-backed bonds, such as those of car-loan companies.
I dont own any Freddies at the moment, says co-manager Jim Kaplan, and have less than 1% of assets in mortgage pass-throughs. Like Mahony, he owns mortgages in the form of Ginnie Mae CMOs.
If you prefer to manage your own bonds, my advice is to put 75% of your fixed-income assets into a Lehman Aggregate index fund, such as Vanguard Total Bond Market Index (VBMFX) or the new exchange-traded iShares Lehman Aggregate Fund (AGG, news, msgs).
Facing higher rates, I would invest the flexible 25% of my portfolio along these lines: 40% in short-term Treasurys (e.g., Vanguard Short-Term Treasury Fund (VFISX)), 40% in intermediate-term Treasury Inflation Protected Securities, or TIPS (such as Vanguard Inflation-Protected Securities (VIPSX)), 10% in foreign developed-market bonds (such as Pimco Foreign Bond (PFORX)) and 10% in emerging-markets debt (such as Pimco Emerging Markets Bond (PEBIX)).
That mix will likely beat the index in the coming year, and it should significantly outperform the typical government-bond fund.
At the time of publication, Timothy Middleton owned shares of Fremont Bond Fund (FBDFX), which is a no-load fund managed by William Gross, manager of Pimco Total Return. He's also writing a book about Gross for John Wiley & Sons, due to be published early in 2004. He owned no other securities mentioned in this article.
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