Subprime woes may spread to bond funds
WASHINGTON -- Could the housing market's woes spread to bonds held in mutual funds by millions of ordinary investors?
Some experts -- and hedge fund investors who have made big bets that the mortgage crisis will worsen -- are saying that's exactly what will happen. Some bond funds that invest in riskier short-term debt already have been whacked by soaring default rates on bonds backed by subprime loans made to borrowers with weak credit.
Bond funds typically diversify their investments to protect investors against losses in any one type of bond. The most risk-averse funds invest solely in U.S. Treasury bonds, while others buy corporate debt and mortgage-backed bonds that may have triple-A ratings but carry more risk than that of the federal government.
Huge losses "won't be the norm" for most mutual funds, predicts Paul Herbert, a senior mutual fund analyst with research firm Morningstar. However, he does expect losses in investment-grade rated bonds backed by the worst-performing mortgages.
Critics have charged that Standard & Poor's, Moody's Investors Service and Fitch Ratings routinely gave triple-A ratings -- the safest rating there is -- to far too many mortgage-backed bonds backed by subprime home loans.
"The rating agencies just completely missed the boat in their methodology for rating these things," said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm.
About 80 percent of debt in bonds backed by subprime loans is rated triple-A, the same rating on virtually risk-free U.S. Treasury bonds, experts say.
The rating agencies defend their methodology and argue the problems of the $10.4 trillion mortgage-backed market are being exaggerated.
S&P, which is owned by the McGraw-Hill Cos., says it only had to downgrade about 1 percent of the subprime mortgage debt the agency has rated in recent years, with the overwhelming majority occurring in the lowest-rated debt. Over the past 30 years, the average 5-year default rate for investment-grade mortgage-backed bonds is less than 1 percent, says Chris Atkins, an S&P spokesman.
"Our long-term track record of assessing credit quality of bonds is exceptionally strong," Atkins said.
Still, Richard K. Green, a finance professor at George Washington University, said he is mystified risky home loans became bundled into triple-A-rated investments.
"The problem is some of these mortgages were just phenomenally bad," he said. "There was sort of an assumption that house prices would never fall. We now see some markets where they are falling quite a lot."
Morningstar, in a report published last month, identified several mutual funds that have invested in short-term bonds -- including subprime debt -- that have suffered losses this year.
Fidelity Advisor Ultra Short Bond A and Fidelity Ultrashort Bond, managed by Fidelity Investments, are both down nearly 5 percent for the year, a sharp drop for a fixed-income fund.
The declines were caused by several factors, including "the fund's holdings in subprime mortgage securities, which have primarily been in the highest-rated AAA and AA (segments of debt)" and exposure to deteriorating conditions in the bond market generally, Sophie Launay, spokeswoman for Boston-based Fidelity said in an e-mail.
State Street Corp.'s Advisors' SSgA Yield Plus has lost 9.5 percent of its value so far this year. State Street declined to comment Friday. The company also declined to deny or confirm a report in the Boston Globe last month, which quoted a letter to State Street clients alerting them to a 42 percent decline this year in the State Street Limited Duration Bond Fund for institutional investors.
Some savvy mutual fund managers have been able to avoid the subprime mess, Morningstar points out, citing the performance of Metropolitan West Asset Management LLC and Legg Mason Inc.'s Western Asset Management.