What Does a Mutual Fund's Average Credit Quality Tell Investors?
Published in the Journal of Investing, Winter 2010, Vol. 19, No. 4: pp. 58-65.
The SLCG study explains that the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios.
Structured Products in the Aftermath of Lehman Brothers
SLCG's prior research showed that structured products were poor investments because they were significantly overpriced when offered and were, at best, thinly traded thereafter. SLCG concluded that overpriced structured products survived in the marketplace because structured products' opaqueness obscured their true risks and costs and the high fees earned by underwriters and salespersons.
The current SLCG study presents a brief history of the structured products program at Lehman Brothers and illustrates many of its points with Lehman structured products examples including Principal Protected Notes, Enhanced Return Notes, Absolute Barrier Notes, Steepeners and Reverse Convertibles. The study reports that the spectacular failure of Lehman brothers in September 2008 left investors holding more than $8 billion face value $US-denominated structured products. Dr. Craig McCann, the study's principal author, explained that the Lehman experience is especially instructive of the opportunity for mischief presented by financial engineering; faced with increasing borrowing costs Lehman stepped up its issuance of structured products where its credit risk would not be priced into the debt.
Charles Schwab YieldPlus Risk
From June 2007 through June 2008, investors in YieldPlus (SWYSX and SWYPX) lost 31.7% when other ultra short bond funds had little or no losses. Schwab had marketed YieldPlus as a low risk, higher yielding alternative to money market funds.
The report concludes that YieldPlus's extraordinary losses occurred because the fund held much larger amounts of securities backed by private-label mortgages than other ultra short bond funds. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus. These private-label mortgage-backed securities holdings had given YieldPlus a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when the value of structured finance securities - especially those backed by mortgages - dropped significantly.
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus.
Regions Morgan Keegan: The Abuse of Structured Finance
Investors in six Regions Morgan Keegan (RMK) bond funds lost $2 billion in 2007. The RMK funds held concentrated holdings of low-priority tranches in structured finance deals backed by risky debt. We provide five examples of the asset-backed securities RMK invested in: IndyMac 2005-C, Kodiak CDO 2006-I, Webster CDO I, Preferred Term Securities XXIII, and Eirles Two Ltd 263.
RMK did not disclose the risks it was taking until after the losses had occurred. In fact, RMK misrepresented hundreds of millions of dollars of highly leveraged asset-backed securities as corporate bonds and preferred stocks thereby making the funds seem more diversified and less risky than they were. RMK and Morgan Keegan also materially misled investors by comparing these funds to indexes which only contained corporate bonds despite the fact the RMK fund held three times as much asset backed securities as they held corporate bonds.
The RMK funds held roughly 2/3rds of their portfolios as of March 31, 2007 in structured finance securities and only 22% or 23% in corporate bonds. RMK's structured finance holdings were roughly 90% in mezzanine and subordinated tranches and only 10% in senior tranches. The vast majority of tranches by market value are classified as 'senior' and so the RMK funds were overwhelming invested in the bottom of structured finance deals'capital structures. The attached Excel file contains SLCG's classification of securities in the RMK by senior versus mezzanine/subordinated.
Download SLCG's Classification
Roughly 90% of the losses suffered by the RMK funds identifiable from their public filings during the last three quarters of 2007 when the funds collapsed were from the funds' holdings of structured finance securities. The attached slides summarize SLCG's classification of losses in the RMK funds in the last three quarters of 2007.
Download the RMK Losses Due to Structured Finance and Internally Priced Securities slide
Download the RMK Losses Due to Structured Finance and Internally Priced Securities backup