Your average retiree probably would never dream of gambling on pork bellies or currency futures. But many risk-averse investors now own racier vehicles without even knowing it. As interest rates have plummeted, managers of even fuddy-duddy fixed-income funds have joined the rush to "derivatives" as a means of plumping up yields and making income as predictable as possible. Most recently, for example, mortgage funds and municipal bond funds have been snapping up securities that are not bonds at all but are derived from bonds: "interest-only strips," "principal- only strips" and "inverse floaters."
So far, shareholders have generally been rewarded, since these highly volatile securities have reacted to a favorable market with more oomph than plain vanilla bonds. But if '94 brings rising rates and a bear market for bonds, derivatives could likewise magnify fund losses. "A lot of the exotica will have to be managed very carefully," warns Bond Fund Advisor Managing Editor Ralph Norton.
Investors in many adjustable-rate mortgage funds learned that lesson the hard way last year, few more thoroughly than shareholders in the Putnam Adjustable Rate U.S. Government fund (800-225-1581). Anticipating higher rates, the fund had stocked up on interest-only strips, a derivative that, unlike a normal bond, pays investors the interest portion of a pool of mortgage payments and not the principal. IOs gain value with rising rates because the pace of mortgage refinancings slows and investors get interest payments for a longer stretch. When rates plunged instead, IOs lost as much as 40 percent of their value. Putnam's 8 percent stake helped put its two ARM funds in the bottom four for 1993 out of a field of 58. Shareholders just about broke even, while ARM funds on average returned 3.8 percent. "We haven't soured on IOs," says acting manager Jeff Saef, "but we're more careful."
Pros who put their faith in principal-only strips last year fared better. POs -- which, as one might deduce, pay just the principal part of mortgage payments -- soar in value when rates fall because prepayments deliver that payoff faster. Managers Intermediate Mortgage Securities fund (800-835-3879) began the year with 20 percent of its assets in POs and netted 20 to 30 percent as rates dropped. The fund returned 11.5 percent last year, compared with 7.5 percent for the average general mortgage fund. The risk: If rates go up and prepayments slow, POs will deflate as precipitously as they gained.
Essentially, the alphabet soup of derivatives that investors in mortgage funds take on are all varieties of the collateralized mortgage obligation, or CMO -- any security backed by a pool of mortgages that has been sliced to meet needs of different investors. Riskwise, CMOs range from benign to superspeculative. So-called planned amortization class CMOs, for instance, are a cautious play; they are designed to ensure level payments at defined intervals over a broad range of interest rate scenarios. Even within one class of CMO, risk varies. Interest-only strips backed by a pool of 8.5 percent mortgages throw off more income than IOs backed by newer 7 percent loans. They're also riskier, since the high-rate loans are more likely to be prepaid.
Both mortgage-fund investors and the tax-shy hordes rushing to municipal bond funds should be on the lookout for inverse floaters, a Wall Street creation that acts very unlike a bond. These derivatives, backed by either mortgages or debt issued by hospitals, power plants and the like, are structured to pay higher coupon rates when an index of market interest rates falls. Managers Intermediate had a 24 percent stake in inverse floaters at the start of 1993, pegged to the London Interbank Offered Rate (LIBOR) index, the rate banks charge each other for short-term Eurodollar loans. As the LIBOR moved to historical lows last year, Managers' inverse floaters returned as much as 20 percent.
Determining whether a fund uses derivatives cautiously or aggressively might require a phone call to the management. Prospectuses and annual reports do not have to be specific about which derivatives a fund holds. Investors leery of extra risk should look closely if a fund's yield is a point or more higher than its peers, says Don Phillips, vice president of Morningstar Inc., a mutual fund information publisher. Likewise, if a fund's yield matches its peers but its expenses are higher.
Lead manager Thomas Poor of Scudder Short-Term Bond Fund (800-225-2470) claims his high-grade, general debt fund takes a defensive approach to derivatives. The 14 percent of Scudder's assets in CMOs are the low-risk PAC type, and the fund's inverse floaters (10 percent of assets) are pegged to the Cost of Funds Index, which reflects bank deposit rates and changes at a much more glacial rate than the quicksilver LIBOR index. Moreover, Scudder limits investment in any single derivative issue to 2 percent of assets. The fund ranks first among its peers for the past five years, returning 10.1 percent annually.
In time, two new rating services could make research easier. Fitch Investors Service and Standard & Poor's now assign risk ratings to bond fund portfolios, digging deeper than credit quality to report on such factors as liquidity, prepayment risks and derivative exposure. The reports are free and can be obtained by calling (800) 75-FITCH or (800) 424-FUND. Fund sponsors pay to be rated, however; so far, few have volunteered.
Staying clear. For now, mortgage investors can limit derivative exposure by sticking with Ginnie Mae funds. Managers are limited primarily to securities backed by Government National Mortgage Association, which guarantees no derivative securities yet -- though it is considering doing so. Among Ginnie Mae funds that shun derivatives: First-ranked Princor Government Securities Income Fund (800-247-4123) and the Dreyfus Investors, Premier and Ginnie Mae funds (800-645-6561), all within the top 10 last year with returns of 6.6 to 9.2 percent.
Muni fund investors are safe with Vanguard (800-662-7447), which limits derivative holdings to defensive plays in general and avoids the new esoterica altogether in its municipal bond group (box); Safeco Municipal Bond Fund (800-426-6730), which returned 12.7 percent last year, is another that has sworn off derivatives. Given Wall Street's enthusiasm, however, the days of derivative-free bond investing are numbered, warns Fitch's John Schiavetta. Or perhaps, as critics fear, the next market rout will do derivatives in.
Ian MacKinnon Bond guru The Vanguard family of funds prides itself on its no-frills, low- cost approach to investing. According to Ian MacKinnon, head of Vanguard's fixed-income group, that tradition is one reason the company has felt free to eschew, for the most part, the new, exotic derivatives.
Q: Why does Vanguard avoid derivatives?
A: We're not philosophically opposed to them, provided proper safeguards are taken. Adequate disclosure, for instance. If Vanguard funds were to use derivatives, we'd want to accurately portray the risks. We're looking at rewriting our prospectuses, but frankly we don't know the best way to explain these securities to shareholders.
Q: What should investors be concerned about?
A: Derivatives disguise traditional measures of risk, such as maturity or credit quality. I have three concerns. One, you can have a derivative with a five-year maturity but the price behavior of a more volatile 20-year maturity, so it's difficult to understand the risk. Second, derivatives tend to be very illiquid, making it difficult to get an accurate fix on market value. Third, these securities have not been tested in a significant down market. My biggest concern is that all owners will try to get out at the same time, buyers would become scarce and sellers would not get good bids.
Q: Who makes the market in derivatives?
A: The brokers who design them. Fund managers trying to sell can get bids from brokers on other firms' products --
