Complex financial instruments called credit default swaps have roiled the financial markets for months. They're at the heart of the bond insurers' woes and were a reason why insurance giant AIG (AIG) just added billions to a planned writedown. But if you think exposure to these derivative securities is limited only to insurers and investment banks, take a good look at your seemingly bland, conservative bond fund.
Start with the world's largest, Bill Gross's $120 billion Pimco Total Return fund. Gross railed against credit default swaps (CDS) in his January investor newsletter, calling them securitized weapons of mass destruction. But the latest holdings for his bond fund, as of Sept. 30, show more than 300 CDS positions, some as large as $200 million.
Gross is hardly alone in dabbling in the swaps, which allow managers to get a bump up in yield as well as hedge their bond positions. Of the 30 largest bond funds, 12 have exposure to credit default swaps, including Oppenheimer Strategic Income, T. Rowe Price New Income, Western Asset Core Plus Bond, Vanguard Short-Term Investment-Grade, and four Pimco funds. Unlike some of the troubled CDS of late, the swaps in these mutual funds aren't necessarily related to subprime mortgages.
Just what are these things? And given the disruption they have caused in the financial markets, should you be worried if they're in your fund? The risks are hard to measure, but it's important to keep perspective: Those 300-plus swaps in Gross's fund represent 4%, or $4.8 billion, of the fund's $120 billion in assets. Gross says his "is the safest fund around."
On the surface, a credit default swap isn't so complicated. A buyer and a seller with differing views on whether a company's credit rating will get better or worse place bets with each other in a private contract. For the buyer, the contract acts as an insurance policy against a company defaulting on its bonds. For the seller, the swap delivers a payment stream over a certain time for providing that protection.
Consider a swap in the $14.6 billion Western Asset Core Plus Bond Fund. The fund has a contract with Credit Suisse First Boston to insure $9 million of Eastman Kodak (EK) bonds. If Kodak goes bankrupt, Western Asset will be on the hook for some or all of the $9 million in losses, which it will pay to Credit Suisse. In return for such insurance, Credit Suisse pays Western 1.4% per quarter on the $9 million. Neither side has to actually own the bond, so pretty much any financial player can place a bet on Kodak's credit quality. All of those bets help explain why the credit default swap market tops $43 trillion, larger than the entire bond market.
Many fund managers see swaps as a way to create a sort of synthetic bond that yields more than the bond the CDS protects. In one basic form, they marry a Treasury bond with the swap. The result is a higher yield than funds could get on a Treasury, or even by holding the corporate bond that the swap transaction insures. Some managers, such as Bob Auwaerter of the $19.8 billion Vanguard Short-Term Investment Grade Bond Fund, which has a 1.5% CDS position, are very conservative and cover their credit default swap positions with liquid, highly rated collateral. Gross says his own fund's swap positions are fully backed by cash.
The problem is that, in many instances, you can't tell how much of a swap position is covered by liquid assets such as Treasury bonds or cash. The amount of highly liquid collateral, in more cases than not, only needs to be the difference between the bond's par value and where it currently trades. So if a bond has a par value of $100 and trades at $90, the fund would need to set aside $10 in collateral to sell CDS insurance on the whole $100. Fund managers like this because they have to set aside just $10 per bond in fund assets as collateral, but they get paid to insure the whole $100. 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.
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