Bonds: Any Subprime Surprises?
As defaults of subprime mortgages continue to rise, it turns out that the affected homeowners and their lenders aren't the only ones hurting. A handful of bond funds got nicked, too. The good news: It appears the damage is limited, with the majority of fund managers having presciently dumped their subprime securities last year or at least limited their exposure. "Fund managers were on to this problem well ahead of the media," says Jeff Tjornehoj, a senior research analyst at Lipper Inc. (RTRSY ), a New York fund analysis service.
Among those licking their wounds are the $1.6 billion Fidelity Mortgage Securities Fund (FMSFX ), which returned just 0.21% through June 11. That's nearly a full percentage point below the performance of all taxable bond funds but slightly ahead of the 0.19% return of the intermediate-bond category, its peer group. It had 18% of its portfolio in collateralized mortgage securities as of Feb. 28, its last report. Regions Morgan Keegan Select High Income Fund (MKHIX ) did better, with a modest 0.69% return. The $1.16 billion fund has roughly 14% of its portfolio in subprime asset-backed securities. Fund manager James C. Kelso Jr. says he's still holding on to his subprime positions because he believes the sell-off was overdone. "Most of what we're holding is [loans underwritten] between '03 and '05," when subprime lending standards were much stronger, says Kelso. "These things go in cycles."
A few funds tried to turn the meltdown to their advantage. Case in point: Late last year, the managers of the Dreyfus Premier Core Bond Fund (DSINX ) bought derivatives that would rise in price if subprime asset-backed securities declined in value. That bet paid off. The fund generated a 0.74% return through June 11.
Still, some analysts worry that the subprime mess could worsen, in part because of rising defaults and in part because some funds are holding collateralized debt obligations. What's more, the stated pricing of these complex baskets of mortgage-backed securities may not truly reflect the impact of those defaults.
It's not easy to determine how much subprime exposure is in a fund. Checking the holdings (sec.gov, click on "Edgar") may not help, since many mortgage securities have generic names—Fremont Trust 2005-2 N3, for instance—that don't reveal their credit quality. Easier to spot are securities created by such subprime lenders as Countrywide Financial, New Century Financial (NEWC ), or NovaStar Financial (NFI ). If anything, the complexity of these securities suggests investing in them is best left to pros.
By Dean Foust