Bond funds: read prospectus carefully

The Wall Street Journal has just published an article, about changes in the safety of bond fund holdings. They advise reading the prospectus, carefully.

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http://online.wsj.com/article/SB117038420974295794.html?mod=mkts_main_news_hs_h

Bond Funds Take on Risk To Lift Returns
Customary Safe Havens Look to Branch Out As Rates Remain Low
By SHEFALI ANAND
Wall Street Journal, February 2, 2007; Page C1

Investors who haven't looked inside their bond funds lately may be surprised at a few things in these supposedly relative safe havens.

Many bond-investing mutual funds now put a sizeable chunk of money in bonds tied to mortgages -- this at a time when the housing market has been losing a lot of steam. Others have bought bonds of financially struggling automobile companies like General Motors Corp. and Ford Motor Co.

These investments -- which can be riskier than the usual fare like U.S. Treasury bonds -- are showing up more often in some bond funds as money managers scramble for ways to boost returns at a time when interest rates on more traditional bond-fund investments remain low.

...

Cooling housing prices haven't affected mortgage bonds much -- so far. That's because a majority of these bonds are guaranteed by government-backed Ginnie Mae or by government-chartered agencies Fannie Mae and Freddie Mac, and thus have low risk of default.

However, these bonds face risk if interest rates were to fall sharply. That would cause mortgage-holders to prepay their loans -- causing the price of the mortgage-backed securities to then tumble.

There's another risk, too. If interest rates rise sharply, some kinds of mortgage securities can lose value. That's because fewer homeowners will prepay their loans, and bond investors have to wait longer to get their money back, which they could potentially have invested at higher rates.</tt> [end quote]

Although most mortgage bonds are backed by the GSEs, this is also problematic. See "Central Bankers Cry Wolf," by Mike Shedlock, for a truly scary scenario.

http://globaleconomicanalysis.blogspot.com/2007/02/central-bankers-cry-wolf.html

This shows that bond funds are adding to their risks, in addition to the usual interest rate risk (of NAV dropping, should interest rates rise).

Yet another reason, to construct a ladder of CDs and bonds, to hold to maturity.

Those whose only option is a fund (e.g. a 401(k)), be aware of the possible added risk.

Wendy