Bond Fund Investors Beware of Credit Default Swaps
Are you investing in conservative U.S. bond funds?  Watch out for “credit default swapsâ€â€” basically a futures contract influenced by whether the bond issuer’s credit rating increases or decreases. Although part of many bond fund portfolios, credit default swaps aren’t subject to strict regulation by the Securities and Exchange Commission. In addition, many bond funds neglect to include details of the related risks in their prospectuses.
Credit default swaps help fund managers realize a slightly higher yield – but with significant risks. First, if the bond issuer defaults, the fund must pay for the loss. In some cases, that means selling other assets that negatively impact the fund’s overall performance. Second, because the price of credit default swaps is based on a “fair value estimate,†the full cost may not be recouped when sold. This makes the stated value of credit default swaps inherently unreliable and pulls the bond fund’s overall Net Asset Value into question. Finally, if the firm on the other side of the transaction, the “counter party,†runs into financial problems, they may not be able to pay the premium for bond insurance.
Because of these risks, credit default swaps can cause major issues with a bond fund’s share price. The higher the percentage of credit default swaps, the greater the risk. Bond fund investors need to examine the level of credit default swaps permitted in their funds, as well as how the fund’s manager handles the associated risks. Funds that neglect full disclosure or appropriate management could be liable for losses.
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