Opaque SEC proposal tries to rein in bond funds

Mutual funds

March 30, 1997|By Jerry Morgan | Jerry Morgan,NEWSDAY

It seems like bond funds are getting a lot of attention these days. Last week we talked about the mutual fund industry's fight with Standard & Poor's over bond-fund risk ratings. At the same time, in another proposal, the SEC is asking whether bond funds that go by the name "short-term" should be managed differently than they are now.

Bond funds, of course, have been neglected since the bond-fund disaster of 1994 was followed by the stock rampage of 1995-1997. But investors just might be looking at bond funds if they decide to rebalance their portfolios, taking some of their stock profits.

The Securities and Exchange Commission proposal seems arcane and impenetrable, and most investors really won't notice any difference, experts say. The changes aren't as obvious, for instance, as those in the SEC's proposal to require stock funds with names that suggest an investment purpose, like a Japan Fund, have 80 percent of their money invested in Japan or Japanese-related stocks, up from the current 65 percent requirement. You could look at the annual report of a stock fund and figure out if that standard was met.

But while the bond-fund change will be opaque to most investors, it is designed to insulate them from some of the worst excesses of 1994.

Those problems included some short-term government bond funds, which were supposed to be relatively safe but which took a beating and a loss in principle when some of their investments proved to have long-term risks. That was because the funds invested in derivatives that gave them a higher return, but with much greater risk.

The change the SEC is seeking would mean that funds whose names include the descriptions "short-term," "intermediate-term" and "long-term" -- which are supposed to have dollar-weighted average maturities, respectively, of less than three years, three to 10 years and more than 10 years -- would have to use something called "duration" to measure the terms.

Lowering risk

The intent is to lower the possibility of unexpected risk in those funds, so that investors get the kind of investment they thought they were buying.

As an example of dollar-weighted average maturity, take a short-term fund with $10 million in it: $5 million in three-year bonds; $2 million in five-year bonds; $1 million in one-year securities; and $2 million in two-year securities. Multiply the dollar denominations of the bonds by their terms -- $5 million times three, $2 million times five, etc. -- and add those up. Then divide that total by the sum of the denominations: $30 million divided by $10 million, or three, which is the average weighted maturity in this case.

As for duration, basically it measures the sensitivity of a bond or bond fund to changes in interest rates. As interest rates rise, the prices of older bonds issued at lower interest rates fall, since their return now looks worse compared with the rest of the market. Conversely, as interest rates fall, bond prices rise.

Remember, a bond fund is one in which an investor owns stock in a company that owns a portfolio of bonds.

The interest rates of the bonds in the portfolio and the prevailing market rates will determine the price of the bonds at any given time. It is the price of the bonds that determines the net asset value of bond funds.

What duration does is "accurately reflect how that bond fund will perform under various interest-rate scenarios," said Anthony Jirole, a principal in the Vanguard Group.

Brent Harris, chairman of PIMCO Advisors Funds in Newport Beach, Calif., said duration "is just a better measure of all the cash flows from a bond. That includes the possible prepayment of mortgages or the call provision on some bonds, whatever the current economic environment."

Once the duration of a fund is derived at, using it is easy. If a fund's duration is three years, and interest rates rise by 1 percentage point, multiply the duration by the rate change to get the change in net asset value.

In this case, it would fall 3 percent. (Once again, as interest rates rise, bond prices fall and vice versa.) So if a fund's duration is five years and interest rates fall 2 percentage points, expect the NAV to rise 10 percent.

Duration target

Duration is a moving target as rates and portfolios change, though it is already used by many managers. What the SEC is asking funds to consider is that if managers want to define the term of a fund by its name, that they keep within the parameters.

But be advised, there is a lot of leeway in these terms. An "intermediate" fund, for example, can have a duration of three to 10 years. That means that a 1 percentage point change in rates can mean a change in the NAV of 3 to 10 percentage points. And a long-term fund is anything over 10 years, so the volatility there is greater.

Still, if you know the duration, you'll have a better idea of the risk you're taking on.

Dalbar, the Boston financial publishing and research service, recently completed a nine-part series on how financial advisers, including bankers, brokers, insurance agents and financial planners, were viewed by their customers.

Now Dalbar is offering to rate advisers based on experience, satisfactory financial results and a clear regulatory record. Dalbar will publish the results under its "Excellence in Advice" program.

This is not a totally altruistic enterprise. Financial firms -- including the first two in the program, American Express Financial Advisors Inc. and LPL Financial Services, a large Boston-based independent brokerage -- will pay Dalbar $500 for each customer interviewed.

Pub Date: 3/30/97

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