Bad may be a little strong. There are not magic signs to determine if you have a bad bond fund. However, as Morningstar explains, there are red flags that investors can look at to determine if they are in a fund that is likely to fail. If a fund has multiple red flags, chances are it is best to leave that fund alone.
Uncharacteristically high yields generally spells trouble for a fund. Yield is generally defined as a snapshot of how much income a fund is paying as an annual percentage of its net assets under management. Just remember there is no such thing as a perfect investment or a free lunch. There isn’t any extra source of return that does not have some corresponding risk. Sometimes that risk takes the form of credit risk, sometimes liquidity risk and sometimes it is simply risk of wild fluctuations in price. Whatever the the risk, it exists. Try not to invest in only the highest yielding funds. Try to determine how your fund of choice performed during the 2008 and 2009 market crisis and see if the amount of loss is something you can stomach in the future.
Look at the fund’s exposure. Is the fund heavily concentrated in a single sector? Is it composed of mostly on issue or one investment? In most cases, diversity is key. If you have a lot of large cap growth funds maybe it is worth exploring small cap funds or fixed income funds instead. Do not put all of your eggs in one basket. In 2008 when the markets crashed, funds with heavy exposure to commercial mortgage backed securities took a big hit. Recently, funds exposed to municipal bonds in Puerto Rico or Detroit are suffering. Diversity helps alleviate some of the burdens of these loses.
Too Much Leverage
There are two types of leverage to consider, personal leverage and fund leverage. Personal leverage is when you take out loans to invest and fund leverage is when your fund takes on leverage. More leverage means more risk because leverage magnifies your gains, but also your losses. Consider the entire composition of leverage you are taking before making an investment.
If you remember one thing from this article is avoid extreme investments. If a fund purports to be one thing but actually looks a lot different than its peers, that’s a red flag. The chase for bond-fund assets is extremely competitive, and it’s always enticing for managers to take on what may seem like a marginal amount of risk in order to make their funds look a little more attractive.
Always consider how much it costs to buy the fund and carry the fund annually in your portfolio. Operational costs are the one thing that will always eat at your profits. When it comes to bond funds, the presence of high costs can be especially problematic.
Gana Weinstein LLP has extensive experience litigating and arbitrating cases regarding bond funds. If you have an issue with a bond fund, you should contact us.