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The subprime mess has had a scattershot effect on stock funds and bond funds alike. Most are doing fine, but here and there you see funds that are really hurting. For bond funds, the key question is whether they own mortgage bonds without government-type promises.
In recent years lenders have stretched their standards to reach borrowers with weaker credit. Securities that included these loans performed well for several years, and the funds that held them did, too, because they featured higher yields than agency mortgages and other types of bonds, and borrowers did a good job of making their payments on time. (To be clear, subprime mortgages are typically considered asset-backed securities because their structures are more similar to other types of bonds fitting into that category, such as credit card receivables and auto loans.)
The music stopped when home-price appreciation began to soften last year. With values dropping, stressed borrowers couldn't refinance or sell to avoid delinquency.
Direct fallout for mutual funds contained
Although funds that held subprime asset-backed securities struggled at points earlier this year, broader troubles have become more apparent in recent weeks. One of the triggers was the collapse of two Bear Stearns (BSC, news, msgs) hedge funds that invested in subprime.And, in early July, Standard & Poor's and Moody's Investor Service announced downgrades and watch notices regarding lower-rated subprime asset-backed securities. (Subprime securities carrying higher ratings, indicating primary claims on cash flows and less exposure to losses, were less affected.) In the week after the July Fourth holiday, S&P downgraded about 500 subprime classes -- which are subsets of mortgage pools organized by characteristics, such as vintage and underlying collateral characteristics, and which are sometimes referred to as tranches -- and Moody's downgraded about 400. They knocked down more securities in the subsequent weeks.
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The good news is that few mutual funds owned these classes. We matched up the list of classes downgraded by S&P on July 12 with a list of holdings for all funds in Morningstar's database, and it appears that only 18 mutual funds owned them. As we have reported in other articles, such as Russel Kinnel's Fund Spy on July 13 (registration required), and in Analyst Reports, Fidelity Ultra-Short Bond (FUSFX) had subprime holdings. Although the company hasn't disclosed the size of the fund's stake, it has indicated that some of the holdings were in lower-rated, that is, A and BBB, subprime asset-backed securities.
Subprime's effect on Fidelity's lineup spreads further, however, because several funds own exposure to very-short-term bonds through an internal Fidelity fund that is similar to Ultra-Short Bond. Ten other funds on our list were also Fidelity offerings, including funds as varied as Fidelity U.S. Bond Index (FBIDX) and moderate-allocation offering Fidelity Puritan (FPURX).
Bond index funds typically do not mimic their bogies precisely, because the indexes have many holdings. The fund was trailing the Lehman Bros. Aggregate Bond Index by just 12 basis points as of July 31, which is less than the amount of its expense ratio, suggesting that manager Ford O'Neil added value elsewhere. (We did notice that the fund was trailing competitor Vanguard Total Bond Market (VBMFX), though.) In addition to investing in the internal fund, Fidelity Inflation-Protected Bond (FINPX) also took stand-alone positions in subprime-related securities.
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Some other funds that also had stakes in the downgraded subprime classes included four Putnam vehicles, a couple of State Street Global Advisors (SSgA) offerings and a JPMorgan Chase high-yield bond fund. The SSgA funds, $291 million Bond Market (SSBMX) and $55 million Intermediate (SSINX), appear to have been hit harder by the losses, posting returns ranking in the intermediate-bond category's bottom reaches in recent weeks and for the year to date. It appears that these funds have also faced shareholder redemptions since the end of June.
Indirect impact widespread
The not-so-good news is that the collateral damage has been much greater. Because of the perception of a slowing housing market and a weakening economy, even higher-rated securities in the subprime realm have traded down.One way to follow subprime prices is to watch the performance of the ABX contracts, which are baskets of bonds organized by credit rating and vintage. For instance, "ABX HE BBB- 07-2," which includes securities originated in 2007 that carry BBB- ratings, was trading at 38.45 on Aug. 13, down from its high of 97.47 earlier this year. "ABX HE AAA 07-2," which includes 2007 securities with AAA ratings, hasn't fallen by nearly as much, but it was still down to 92 on that same day, off from an earlier high of 99.33.
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