Credit Default Swaps: Is Your Fund at Risk?

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The fund is still exposed to $90 per bond of losses if the issuer defaults. And if that happens, the manager may need to sell other less liquid assets, which could hurt the fund's performance.

Managers have latitude in how they play the swap game. "The legal restraints on swaps in mutual funds are modest," says Roger P. Joseph, a securities lawyer at Bingham McCutchen in Boston. "At the end of the day you're looking at the manager to make sure you're taking on the right level of risk." That said, Securities & Exchange Commission rules wouldn't allow the value of a fund's swaps to exceed that of the rest of its portfolio. So a fund with $100 million in assets couldn't sell more than $100 million of swaps.

Shareholders looking for clarity on a fund's derivative holdings won't find it in fund reports. Gross acknowledges that disclosure about CDS is an industry problem. "It has only been six months since people have known what credit default swaps are," he says. "The SEC has got to catch up." An SEC spokesperson says there are "no specific plans at present, pending staff analysis" to change fund reporting requirements. As for Pimco's report, Gross says, "give us some time to make adjustments. Check in six months, and if we haven't made some adjustments to our reports, then it's our fault, nobody else's."

Better disclosure won't help with one fundamental problem—the difficulty of valuing some swaps. If a fund had to sell its swap positions because of redemptions or a market crisis, it could be hard to know what they'd fetch in a potentially illiquid market. In many cases, funds apply what is called "fair value" to a swap's price using complex algorithms. "Fair value is more of an art than a science," says Michael S. Caccese, a fund attorney at law firm K&L Gates in Boston. Some funds say they can easily get prices on swaps from brokers. Richard C. Whalen, managing director of Institutional Risk Analytics, a Torrance (Calif.) bond and derivatives analysis firm, doesn't dispute that but says, "The question is, could you trade on that price?"

Default swaps also mean judging the creditworthiness of the institution on the other side of the deal (in industry lingo, the counterparty). With the Western Asset example, the firm is exposed to credit risk not just from Kodak but also from Credit Suisse. If Credit Suisse ran into serious problems, Western might not get its 1.4% quarterly payments, and the value of the swap would fall. Currently the $14.6 billion Western Asset fund has $9.8 billion in swap exposure with 11 counterparties. Stephen A. Walsh, Western Asset's deputy chief investment officer, says the firm reviews counterparties very closely. "We have a separate compliance group that does its own counterparty credit analysis," he says. "There are all sorts of capital hurdles counterparties need to overcome before we deal with them."

Still, with credit problems raging, it's hard to find a financial institution whose capital hasn't been affected by the credit crunch. Gross says counterparty risk is "part of my concern about credit default swaps in general." He argues that Pimco screens counterparties much as it does its corporate credits. "If you selectively choose your counterparties, a credit default swap is tantamount to a regular corporate bond," he says. The fund currently has five counter- parties, he notes. Who are they? Gross wouldn't name them.

Business Exchange related topics:
Credit Default Swaps
Derivative Securities
Financial Services Industry

Braham is a freelance writer in Brooklyn, N.Y.