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Thursday, September 30, 2010

Active Bond Fund Investors Beware :Your Fund May Be More Risky Than You Think

 That actively managed bond fund you own may be more risky than you think The wsj reports

my bolds my comments in blue

How Safe Is Your Bond Fund?

A Change in How Portfolios Are Rated Gives More Weight to Risky Holdings

Your bond fund may be riskier than you think.
For years, the fund industry and research firms such as Morningstar Inc. have assessed the safety of bond funds by analyzing their holdings' underlying credit quality. Now, amid concerns that the measurement could understate the risk that the bonds will blow up, Morningstar has changed its methodology to count lower-rated bonds more heavily.
The move—which took effect Sept. 1—means that more than half of the domestic taxable bond funds tracked by Morningstar saw their so-called average credit-quality ratings fall under the new methodology.
In some cases, people who thought they were investing in an investment-grade bond fund may find themselves in a portfolio whose credit risk is more like a junk-bond fund, says John Rekenthaler, Morningstar's vice president of research.
About 43% of bond funds fell by one credit grade and about 13% dropped by two credit grades, according to Morningstar. A few funds—including Federated Real Return Bond Fund, Cavanal Hill Intermediate Bond Fund, Neuberger Berman Short Duration Bond Fund and TCW Short Term Bond Fund—dropped by more, in some cases to non-investment-grade ratings, such as BB, from investment-grade ratings, such as AA. (See table.)

Of course it's the lower credit quality of the assets not the manager's skill that likely accounted for the higher returns of thse funds compared to those short term bond funds that held higher qusality assets such as a short term treasury fund.. That has worked well recently as credit spreads ahve narrowed. But of course when a crisis hits the lower credit quality bonds will suffer. And given that many investors view short duration bond funds as the stable core of their portfolio...that could lead to some unpleasant surprises.

 ....the percentage of domestic taxable bond funds that had average credit ratings of "AA"—or investment-grade status—fell to 13.85% under the new methodology from 36.38%. Funds with average credit ratings of "BB"—or junk-bond status—more than doubled to 13.36% under the new system from 5.49%. "If the credit rating moved down more than one notch, I'd look closely in making sure you understand the strategy of the fund," says Morningstar's Mr. Rekenthaler. "If it only moved down a notch, I wouldn't worry about it at all."
Bond funds that invest mainly in corporate bonds and private mortgages were generally the most affected, he says. Funds that employ a "barbell" investing strategy—investing in extremely safe investments at one end and higher-risk investments at the other—also tended to see big drops in their average credit-quality ratings.

I doubt many individuals investors have the time or the skill to drill down on the strategy of their active bond fund manager and even if they did the data they would be using would be quarterly in arrears so it would not give a real time view of the fund holdings and strategy.

My solution: invest in a bond index fund or etf you will have total transparency and know exactly the characteristics of your portfolio in terms of duration, maturity, and credit quality.

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