Wednesday, November 26, 2008

Fixed Income Bond Funds Might be as Dumb as ETFs

I'd like to continue my train of thought from yesterday about the difficulty of using instruments like ETFs to actively manage exposure to the bond market. BTW, I may not have been clear in my post yesterday that potential exposure to additional volatility through FI ETFs would come from hedge funds and individual investors who actively trade these instruments. Such volatility would less likely originate with the trading activity of the ETFs' fund management companies (BGI, SSgA, etc.) because their corporate size gives them the ability to buy bonds in bulk to fit their products' maturity ranges.

Anyway, let's see what happens when fund management companies offer actively managed bond funds, rather than ETFs. PIMCO stated today that one of its muni bond vehicles may have trouble delivering dividends to its investors:

PIMCO California Municipal Income Fund II (the "Fund'') may be required to delay the payment of the declared November dividend and the declaration of the next scheduled dividend on the Fund's common shares.

Continued severe market dislocations have caused the value of the Fund's portfolio securities to decline and as a result the Fund's asset coverage ratio has fallen below the 200% Level.

If the 200% Level is not met on December 1, 2008, the Fund would have to postpone the payment of the previously declared November dividend and the declaration of the December dividend until the situation is corrected. Depending on market conditions, this coverage ratio may increase or decrease further.

The fund's stated objective is to provide current income; failure to make a dividend payment means it has failed this objective. I am not a securities attorney, so I cannot say whether this exposes PIMCO to some kind of liability. I would say, as a private investor, that any fixed income fund that can't meet its performance objectives because of market volatility, and not for reasons such as asset impairment or fund company bankruptcy, is not worth my personal consideration. If an investor holds a comparable bond portfolio as individual securities and not as part of an actively managed fund, the investor would receive the coupons on schedule.

This isn't just a problem with PIMCO's Cal muni fund. Some of their other funds have hit the same snag:

PIMCO Corporate Income Fund and PIMCO Corporate Opportunity Fund (each, a "Fund'' and collectively, the "Funds'') today announced that each Fund will redeem, at par, a portion of its auction rate preferred shares ("ARPS''), beginning December 15, 2008 and concluding on December 19, 2008. The Funds also announced that they may postpone the payment of previously declared November dividends for common shares and postpone the declaration of dividends for common shares, currently scheduled to occur on December 1, 2008.

But wait, there's more! Other PIMCO funds had problems just last week that will prevent them from paying declared dividends:

The Boards of Trustees of PIMCO High Income Fund, PIMCO Floating Rate Income Fund and PIMCO Floating Strategy Fund (each, a "Fund'' and collectively, the "Funds'') today announced each Fund will redeem, at par, a portion of its auction rate preferred shares ("ARPS''), beginning December 8, 2008 for PHK and PFN and December 10, 2008 for PFL and concluding on December 12, 2008 for all Funds.

PIMCO is regarded (by those same market "experts" who told us securitization of debt was a great innovation) as a firm chock full of bond expertise. If this vaunted expertise couldn't anticipate a volatility-induced payment stoppage in several bond funds, then what exactly are investors getting by paying PIMCO to actively manage their bond money? PIMCO sure has a snazzy website for press releases, which curiously doesn't feature the releases noted above. Any asset redemptions (sales) PIMCO has to make to meet that 200% threshold may come back to investors as taxable capital gains distributions from the funds! Aw, that's just great (sarcasm filter off).

Here's my approach to fixed income investing. I currently use some fixed income securities (CDs, Treasuries, corporate notes, and others with short-term maturities) as my cash management strategy for the proceeds I collect from selling options. I buy them and hold them to maturity. It's that simple. At some future date I'd be willing to buy long-term bonds to protect my principal and get some form of interest rate immunization, but once again I will hold them to maturity. I am not going to waste my time or money actively trading bonds to try to outguess the Fed's interest rate changes. I have a life, you know.

Oh yeah, PIMCO is yet another firm that never responded when I sent them my resume. Now they're having problems. Coincidence? I don't think so. ;-)