The Piper Jaffray Institutional Government Income Fund earned an unenviable spot in mutual-fund history. In four months in 1994, 27% of the fund's net asset value evaporated as interest rates rocketed and bond prices plunged.
Nothing in the usual complement of fund data hinted such a debacle was coming. The fund was No.1 among short-term government bond funds, according to Lipper Analytical Services Inc.; it also earned five stars, the highest rating awarded by Morningstar Inc. The portfolio, comprising U.S. government and agency issues, merited an AAA credit rating from Standard & Poor's. (S&P is a unit of The McGraw-Hill Companies, parent company of BUSINESS WEEK.) None of these measures addressed the cause of the meltdown: a volatile mix of mortgage derivatives and portfolio leverage that blew up when rates ran up quickly.
TO THE RESCUE. The risk in owning government bond funds is not in the credit rating of the bonds, but rather in what happens to interest rates, or what is called "market risk." The longer the bond's maturity, the more sensitive it is to changes in interest rates. The returns from bonds can gyrate wildly (chart)--and so can returns to bond funds. Derivatives or leverage magnify those swings.
To the investors' rescue come the ratings agencies. S&P, Moody's Investors Service, and Fitch Investors Service have developed "market risk" ratings that would flag some of the potential problems in bond funds that wouldn't be caught by ratings based on past performance or credit analysis. Yet only about 100 funds have been rated so far. The reason: NASD Regulation Inc., an organization set up by the National Association of Securities Dealers, must approve the information that goes into fund sales literature and so far has barred funds from using the ratings in shareholder communications. The main concern, says Clark Hooper, senior vice-president for disclosure and investor protection at NASD Regulation, is the "predictive nature" of such ratings and what inferences investors might make about future performance from them.
A legit complaint? Of course those new ratings are predictive. In essence, if interest rates move up, for example, the ratings predict that funds with the lowest market risk should sustain the least damage, and those with higher risks the most.
Market risk ratings can do a better job in defining the risks that investors face than the data that funds are allowed to use in advertising, such as past performance, Morningstar ratings, or credit ratings. To be rated for market risk, funds have to provide detailed portfolio information monthly (the law requires only seminannual reports), and the ratings agency can always request more frequent reports. Because these ratings require the fund manager's cooperation, funds must ask for--and pay for--the ratings. The practice is no different than when a bond issuer pays for a credit rating, hoping the rating will make the bonds more attractive to investors.
Market risk ratings depend mainly on an assessment of the "duration" of the fund's portfolio. That assessment entails an examination of the maturities of the bonds in the fund as well as their coupon payments, which together determine how volatile the fund is. The higher the duration, the more volatile the portfolio. For example, a fund with a duration of 10 would likely drop 10% in value if interest rates rose one percentage point. Right now, funds give shareholders information on maturity, but not all funds disclose duration--and if they do, they don't all use the same methodology for calculating it.
PROMISING RESULTS. Durations are amplified when funds use derivatives. So portfolios must also be examined for such duration-sensitive investments. Among the other factors that go into ratings include liquidity, diversification, and for global bond funds, currency risk.
Although these ratings have not been around long enough to conclude that they accurately assess market risk, early returns are promising. According to S&P, risk-rated bond funds generally earned returns in 1994 and 1995 in line with their ratings. For instance, the highest-rated funds did best in 1994, a year of rising rates, and the low-rated funds did best in 1995, when rates fell.
Hooper says NASD Regulation is trying to accommodate the market risk ratings, will ask for public comments, and hopes to resolve the dispute early next year. But it's the NASD itself, by blocking the advertising of risk ratings, that has created the dispute.