Junk-bond funds' collapse had a lesson: Run away

Your Funds

Dollars & Sense

April 01, 2001|By CHARLES JAFFE

IF THERE IS solace to be taken from the current market downturn, it's that someone else most likely has done worse than you have.

For mutual fund investors, those sad sacks are not the ones who invested in downtrodden tech funds.

No, the technology meltdown is mild compared with the nightmare endured by investors in three junk-bond funds run until last week by Heartland Advisors. The funds - some of which had a five-star rating from Morningstar Inc. as recently as summer of last year - were taken over by the Securities and Exchange Commission March 22, a move designed to restore some sanity to a situation that had spun out of control.

The lessons in the Heartland case are several, but the biggest one may be that some bad investment situations truly are beyond hope.

To see that, we need to recap the story of how three funds with good track records wound up being the first issues in more than a decade to be put into receivership by the SEC.

Heartland High-Yield Municipal, Heartland Short Duration High-Yield and Heartland Taxable Short Duration Municipal invested heavily in illiquid, unrated junk bonds. Many funds won't touch unrated junk or limit the percentage of a portfolio that can be dedicated to it. Heartland feasted on this stuff.

For a while, it worked. The worse the junk, the better the return, and the three funds posted good numbers, drawing attention and assets as they grew to a combined $200 million.

But the junk market started drying up last summer, and the real value of bonds in these funds came into question. When the prices of the bonds were adjusted in October to what was considered a fair-market value, two of them basically collapsed. High-Yield Municipal shares suffered a one-day loss of 70 percent, and shareholders in Short Duration High-Yield took a 44 percent haircut.

The first of nearly 20 class action lawsuits was filed against Heartland almost immediately.

The two funds finished last year down 63 percent and 43 percent, respectively, devastating for investors who thought they were getting the safety of a bond fund. (The taxable muni fund also suffered a price adjustment, though it wasn't as severe as the others.) It didn't scare all shareholders into selling. Exact numbers aren't available, but the price changes shrank the combined assets of the three funds to $100 million or less. From there, investor redemptions brought the funds to their current $30 million.

All investors should have run away once it was clear that the problems were management's doing, rather than the market's.

First, Heartland said the funds would dip into assets to defend against the lawsuits (the funds were named a co-defendant in most of the filings).

Then, one of the fund managers brought in to clean up the mess left, after four months on the job. At the same time Heartland disclosed his departure, the company altered its prospectus on the three funds to say they were veering from the funds's investment objectives, opting for safer bets such as Treasury securities.

Once the funds stopped serving their intended purpose, all remaining investors should have raced for the exit. They didn't.

Finally, the SEC stepped in. Heartland's auditors had been unable to determine an accurate value for the junk. Without an auditor's opinion, Heartland couldn't generate financial statements, specifically its annual report. That's a violation of the Investment Company Act, which governs mutual funds.

"It became clear last week that they were not going to issue audited financial statements, and any they issued would go with a disclaimer that basically said there was no way to know how accurate and correct the information was," said Tim Warren, associate regional director for the SEC's Midwest Regional office in Chicago.

"Without accurate financial statements, shareholders don't have the information they need to decide if they want to stay in a fund or sell it."

The SEC turned the three funds over to Chicago securities lawyer Phillip Stern to determine what happens next. (The action affects only the three funds; the rest of Heartland's issues are unaffected and have had a good year thanks to the rebound in value stocks.) Assets in the funds are frozen until Stern decides whether to liquidate them, sell them to another firm or to resume operations. Investors can neither redeem shares nor buy more (not that they'd want to).

Heartland agreed to the deal, without admitting any wrongdoing.

The moral of the Heartland story: There's a big difference between riding out a downturn and staying put for a disaster. You may want to stay with a fund that the market is against, but once management shows you that it's truly inept, leave in a hurry.

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.