Almost always, when people are very angry at the mutual fund industry, it's because of bond funds.
Stock funds rarely deliver unhappy surprises. By now, people have a pretty good sense of how buckets of stocks behave. In the past quarter-century, U.S.-stock fund investors have been disappointed only three times. In 1987, they were caught out by the speed of the market's plunge (22% in a single day!); in 2000-02, by the depth of technology stocks' dive; and in 2008, by pretty much everything. Following all three occasions, redemptions ensued. Even then, though, most investors were disappointed in the asset class rather than in the funds per se. They realized that the funds had only gone where the asset class had led them.
Bond funds are a different matter, as they do not behave so predictably.
In part, this occurs because bond funds are sometimes a strategy, rather than a collection of securities that can be tracked by an index. In the U.S the "government plus" funds of the 1980s, for example, consisted of long U.S. Treasury bonds, against which call options were sold. (The joke among Morningstar analysts was to call those funds "government minus." Fund analyst humor is not the highest form of the art.) There was no index for government bonds that wrote call options. Five years later, short-term multimarket income funds purchased higher-yielding European currencies and shorted lower-yielding currencies. No index for that, either. Consequently, when those funds declined in price, they caught their shareholders unawares. Investors knew not why the losses happened. They just knew that something was wrong, and they wanted out. Neither of those fund categories now exist.
The other reason that bond funds catch investors unawares is that, for competitive reasons, conventional-looking and conventional-sounding bond funds will often buy heavily into unconventional sectors. Exotic mortgage tranches, emerging-markets securities, and high-yield credits, among others, can do much to push a fund's yield (or total return) above that of its peers. When bad news strikes, those unconventional bonds can lose money in a hurry--coming as quite a shock to investors who didn't know that they owned those securities in the first place.
The worst cases occurred in 2008, which was as much of a disaster for exotic bonds as it was for common stocks. Many funds that marketed themselves as thoroughly safe, with comforting labels like "short term" or "limited duration," dropped 20% or more for the year. Not only did shareholders have no reason to expect such a performance--it's not as if any of those bond funds' managers had warned of such a possibility--but, once the damage was done, they also faced depressing math. Perhaps stocks could quickly recoup their large losses; after all, stock prices can move up in a hurry. The prospects for a rapid recovery seemed much dimmer with the bond funds, though. Once again, investors cleared out.
On none of those occasions did I recognize the danger before it occurred. (Even if I could forecast market woes, it wouldn't be with subsegments of the bond market.) Nor did I necessarily realize which funds would be harmed once the downturn began--because often, it's difficult for anybody who is not a bond trader to understand just what the heck that particular bond does. Is it a mainstream, plain-vanilla version of an asset-backed security, which should fare just fine in the downturn? Or is it one with cash flows that dry up at the first sign of recession? You got me.
So, I am in no position to post any specific warning.
What I can share, though, is that I have a bad feeling about this. It seems about time for the next bond fund scandal. It's been five years since the last scandal, which is a longer-than-usual respite. Meanwhile, competitive pressures to use exotic strategies and securities are rising. Cash is no longer flowing strongly into bond funds, thereby floating all boats. Thus, new sales must be won by wresting monies from other bond funds. In that contest, posting a high yield is very, very helpful.
Meanwhile, bond funds are more opaque than ever. Almost every U.S. bond fund has an underweighting to simple-to-understand Treasuries as compared with the Barclays U.S. Aggregate Bond Index. In Treasuries' place, the funds own more corporate bonds, mortgages, asset-backed securities, and foreign issues. (Investment-grade corporates aren't terribly dangerous or difficult to assess, but many ostensibly high-grade bond funds dabble in junk.) There is also increased use of long-short strategies and swaps. (When I asked Morningstar analyst Ben Alpert if bond funds continue to increase their use of swaps, he replied, "Finding a major bond fund that doesn't use a swap is a lot harder than finding one that does.") Swaps not only are difficult to model, but they also can quietly give a fund exposure to an asset or security type that shareholders don't even realize the fund owns. Swaps increase the possibility of surprises.
Finally, per a major investigation by Peter Lee of Euromoney (the story is firewalled, but this synopsis by Felix Salmon is not), the global bond market currently faces a worrisome threat to its ability to conduct trades. The broker/dealers who historically have greased the bond market's wheels have largely retreated from the business, such that the ratio of their inventory to the amount of overall assets is at a record low. It wouldn't take much unusual sales activity for the gears of the marketplace to freeze up, as they did in 2008 during the financial crisis. When liquidity stops, prices plunge.
Perhaps that problem will be averted. Perhaps, too, economic conditions will remain healthy enough so that, as with the past five years, the higher-risk segments of the bond market will continue to thrive. Again, I make no predictions. I only say that if I were seeking a bond fund today--which I am not--I would seek a plain, Treasury-heavy fund. Now seems the time for the "risk-off" trade for bonds, as opposed to "risk-on."
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.