Investors in conservative U.S. Bond Funds should be on the alert for possible risks in such funds due to the existence of so-called “credit default swaps” in the fund’s portfolio. These investments – essentially a futures contract tied to whether a bond issuer’s credit rating will get better or worse – are not strictly regulated by the Securities and Exchange Commission and details regarding their risks are not typically explained in the fund’s prospectus.
Many bond fund managers use these swaps as a way to achieve a slightly higher yield for the fund. Unfortunately, there are various significant risks associated with these types of arrangements. For example, if the bond issuer defaults, the fund, which has essentially agreed to insure against default, is required to pay for the loss. This could result in the fund manager having to sell other fund assets, thereby dragging the fund’s performance. Additionally, credit default swaps are carried at values that are unreliable and may result in overstatement of the fund’s Net Asset Value. The price of credit default swaps is based on a “fair value estimate” that may or may not be realized when it comes time to have to sell it. Thus, the valuation of these instruments is inherently unreliable. Finally, fund managers are exposed to the risk that the institution on the opposite side of the transaction, “the counter party” may experience financial problems that would interfere with its ability to pay the premium for insuring the bonds.
These risks could pose serious problems to a bond fund’s share price, particularly if the bond fund exposes a large portion of the portfolio to these instruments. Investors should monitor the levels of credit default swaps permitted in any bond fund, and how the credit default swap risks are managed.
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