When the stock market swooned between 2000 and 2002, the Federal Reserve repeatedly cut short-term interest rates, until the “fed funds rate” reached its nadir at 1 percent in June 2003. Cash-like investments, such as money market funds, bank savings accounts and short-term certificates of deposit, were directly impacted by these changes. When the fed funds rate dropped to 1 percent, yields on safe, cash-like investments fell to levels barely above zero.
Yield-hungry investors searched for ways to improve these meager yields, and Wall Street rode to the rescue with “enhanced yield” offerings. Unlike money market funds, the enhanced yield funds were actually ultra-short bond funds. These funds were held out as a way to earn perhaps 1 or 2 percent more than a money fund with little additional risk and stable share values. Very popular, by 2007, enhanced yield funds (taken together) counted about $850 billion in assets.
For four years, enhanced yield funds performed about as expected. But a funny thing happened on the way to the subprime mortgage crisis. Beginning in the summer of 2007, difficulties in the complex securities that had helped fuel the housing bubble exposed enhanced yield funds for the high-risk vehicles they really were.
The term “ultra-short” refers to the duration of these bond funds. “Duration” is a term of art that refers to how long it takes an investor to receive all the cash flow from a bond, including both interest and repayment of principal. For example, a newly issued bond with a 6 percent yield that pays interest every six months until it matures in 10 years works out to have a duration of 7.7 years, while the same bond with a one-year maturity has a duration of just under 1 year. The greater the duration, the greater the interest rate risk the bond buyer takes on.
In the world of bond funds, a short-term fund would typically have a duration between 1 and 3 years and would be considered to have low interest rate risk. The enhanced yield ultra-short funds typically kept their durations well below one year, with the idea that interest rate risk would be nearly nonexistent.
Traditional bonds are beautifully simple, in that their investment characteristics are highly mathematical. One can predict that a portfolio of straight bonds with a duration of, say, 5 years, will decline 5 percent in value for each 1 percent rise in prevailing interest rates. Conversely, the value of that same portfolio will rise about 5 percent for each 1 percent decline in prevailing interest rates.
Unfortunately, the enhanced yield folks turned the duration-value principal on its head. Instead of buying short-term straight bonds, they loaded up on very long-term floating rate bonds, ones whose interest rates reset typically every three months. Theoretically, these floating rate bonds were supposed to have the same duration as bonds maturing in three months, barely responding to changes in interest rates. To make everyone feel better, enhanced yield funds managed to include enough bonds rated highly by agencies, such as Standard & Poor’s and Moody’s, to say their portfolios were solid investment grade.
Over the past nine months, the news for enhanced yield funds has been almost unremittingly bad.
Last fall, Federated Investors, one of the larger money market fund operators, had to bail out its Enhanced Reserve fund. General Electric Asset Management’s Enhanced Cash Fund, with about $5 billion in assets, offered to redeem shares at $0.96 on the $1.
One of the most highly visible enhanced yield funds is the Schwab Yield Plus Fund, widely held by individual investors. Begun at the end of 1999, Yield Plus was well positioned for the surge of assets that began in 2003. And by last summer, investors had poured more than $13 billion into the fund. Since July, the share price, which was supposed to be stable, has plunged from $9.70 to $8.89 per share. As this column is being written, assets in Yield Plus have shrunk to less than $6 billion.
Being a publicly traded mutual fund, Yield Plus must redeem its shares at their net asset value on a daily basis. As credit worries erupted last summer, savvy investors looked carefully into the Yield Plus portfolio and didn’t like what they saw. The portfolio was dominated by illiquid bonds of questionable credit quality with maturities ranging to 40 years and more. Worse, the fund was locked into securities with interest rate reset terms that are significantly less favorable for investors than similar publicly traded, high-credit-quality issues today. At this time, there simply is no market for much of what Yield Plus holds.
Investors began to pull their money out of Yield Plus in a big way. In a late January conference call, the fund manager indicated that redemptions were running $25 million to $30 million a day.
This puts Yield Plus in a difficult bind. Because they’re required to redeem shares daily on demand, they must value their illiquid holdings every day where no actual market exists to set those values. If the securities are overvalued, investors seeking to redeem shares will be paid more out of the fund’s cash holdings, leaving the remaining shareholders holding overvalued assets. If the securities are undervalued, the published net asset value of the fund will fall further, inducing more investors to redeem their shares.
As sizable redemptions occur, the remaining fund portfolio becomes ever more concentrated in illiquid, longer-term, lower credit quality, poorer-yielding bonds. Fund performance suffers, which then induces more investors to cash out.
What’s happened to Yield Plus and other enhanced yield funds is akin to a slow motion bank run, when depositors are worried they won’t get back their deposits. Nobody wants to be last out the door. Yield Plus’ survival is an open question.
