2011-03-31

Looking at Fidelity's "Ultra-Short" portfolio

It's been many years since I've looked inside a prospectus or an annual report of a US mutual fund. Indeed, what is there to look for? The fund name and its classification on a site like Morningstar.com gives you an idea of what it is supposed to invest into, and if you are curious what it actually is investing in, you can just see the top holdings on Morningstar. So why bother with the prospectuses? A few days ago I was reviewing with a friend the list of mutual funds her 401(k) provider, Fidelity, was offering. "Well, stock funds invest into stocks, bond funds invest into bonds... With a long bond fund you'll get a higher current yield, but a risk of a greater capital loss when the interest rates go up; with a medium, or short bond fund, the current yield and the risk of a capital loss are both smaller. Oh look, they offer an Ultra-Short Bond Fund - that ought to be just like a money market fund, similarly low yields, but practically no potential for capital loss. Let's see what their record is actually like..." Well, it turned that Fidelity Ultra-Short Bond Fund (FUSFX) has had quite a remarkable record: while bringing positive returns comparable to the (low) short-term interest rates most of the time, it managed to lose about 15% of its net asset value during the period of about 2 years in 2007-2008. How do "normal" bond funds - that is, fund that invest into bonds (corporate or government debt obligations, or repackaged mortgages) lose money over a particular period of time? Well, there could be several possible reasons for a loss: * Bond issuers defaulted on some bonds * The perceived risk of default on some bonds increased, and the market value of the said bonds correspondingly dropped, even if no actual default happened * Current interest rates rose, so the market value of longer-term bonds correspondingly fell The first situation, of course, signifies a permanent loss, The second and the third situations are, in a sense, a "recoverable" loss: if you hold a bond to maturity, you still will get your principal back, plus the interest, so a fund that does not need to sell its holdings well eventually get its NAV back to the pre-drop position. So with a truly short-term bond fund such problems normally should not be an issue. So what ever happened to FUSFX during the financial crisis and market meltdown in 2007-2008 - did some 15% of the bonds in their portfolio default? That would be a remarkable thing indeed. The fund's current prospectus (2011-02-11) and annual report (2010-07-31) do not contain much of anything that would allude to the circumstances of the events of 2007-2008. "The fund seeks to obtain a high level of current income consistent with preservation of capital"... "investing at least 80% of assets in investment-grade debt securities"... "similar overall interest rate risk to the Barclays Capital 6 Month Swap Index".... "dollar-weighted average maturity of two years or less." There is this, "Engaging in transactions that have a leveraging effect on the fund, including derivatives", which of course can leverage the fund either way... and yeah, "Derivatives include ... credit default swaps (buying or selling credit default protection)." But the list of fund's holdings in its current annual report contains no such instruments - just a boring list of government and corporate bonds and mortgage securities. It took some effort to locate the fund's old annual reports or investment holdings lists at EDGAR, but when I found one (holdings as of October 31, 2007 ), it made for a surprising reading. After a long list of debt obligations, an inconspicuous section followed, called "Swap Agreements", and full of "Credit Default Swaps". What kind of animal is that? Well, here's one of the many items of this kind that the fund's portfolio contained at the time: * Receive monthly notional amount multiplied by 3.86% and pay Morgan Stanley, Inc. upon credit event of Merrill Lynch Mortgage Investors Trust, Inc., par value of the notional amount of Merrill Lynch Mortgage Investors Trust, Inc. Series 2006 HE5, Class B3, 7.32% 8/25/37 * Expiration date: Sept. 2037 * Notional amount: $600,000 * Value: $(504,664) (that's negative half a million dollars). This is, how I understand it, this works. Morgan Stanley bought a fairly high-interest (7.32%) and long-term (matures in 2037) mortgage-based bond from Merrill Lynch. Being clever enough, they understood that something may happens over the next 30 years, so they went to Fidelity and bought an insurance against the default of that bond. That is, Morgan Stanley would give up part of the interest payments they received on the bond (I suppose they really meant 3.86% per year - that is, over half of the entire interest - rather than per month, since the latter would just make no sense, even in the depth of the credit crunch), and Fidelity (actually, this particular Fidelity mutual fund) would reimburse Morgan Stanley for any losses incurred if Merrill Lynch (or, actually, the underlying mortgages) were to default. Apparently a default, or near default did happen, since the value of the contract with the notional value of $600K is shown to be a negative $504K. Now, half a million dollar loss is almost nothing for a billion-dollar fund, but the fund had quite a few contracts like this, as well as some interest-play instruments (total return swaps), with the "nominal" of $8M and the total value, as of that moment, of minus five million dollars. This, apparently, was already after some of that portfolio had been liquidated: an earlier (Oct 31, 2006) report shows quite a bit more of those, with the total nominal of $18M of credit default swaps and $9M of total return swaps, and a slightly positive total value. Besides playing an insurance company and insuring other companies against the default of third parties, FUSFX owned a good load of such bonds outright. About 30% of their assets at that moment was in "Asset-Backed Securities", some of which apparently, were in the dire need of insurance themselves: e.g., quite a few obligations from the "Accredited Mortgage Loan Trust" or "ACE Securities Corp. Home Equity Loan Trust" were shown as valued at 10-30% below the face value, and a few had lost over 2/3 of their value. So basically here we have it: a mutual fund with a mandate for preservation of capital gorges on some subprime mortgages with 30+ year maturity, and as if that's not enough, insures other companies against the default of similar instruments that they have. The net result, the "ultra-short bond" fund loses about 15% in a two-year period, while Fidelity's regular bond funds (including the GNMA one) are doing reasonably alright over the same time frame. No wonder that soon after the 2007-2008 debacle Fidelity ended up changing the fund's manager. A lesson for consumers? Sometimes it may pay to look into you fund's recent annual report, and to understand what exactly the things in their portfolio are.

No comments:

Post a Comment