Bond Funds Aren't Always as Conservative as Their Names

I received a semiannual report dated June 30 for ACM Government Securities (GSF) a couple of weeks ago. It's 70% Treasury securities and 30% foreign governments. Conservative? It shows a $93 million derivatives loss -- 14% of assets! And since June 30, the price has lost another dollar.

Also, Dreyfus Investment Grade Bond [which has (DRITX)Intermediate Term and (DSTIX)Short Term portfolios] redefined investment grade as anything above C when I called to complain about performance.

This is professional management? Is this common practice?

-- Barry Wolfe

Barry,

Unfortunately, the short answer to both questions is yes.

The long answer should begin by pointing out that most of that $93 million loss ACM Government Securities suffered was on primary investments rather than derivatives. More on that later.

The important lesson here is this, and it's timeless: You can't judge a bond fund by its name.

Neither Alliance Capital Management, which runs ACM Government Securities, a closed-end fund, nor Dreyfus, has done anything wrong. Under the federal law regulating mutual funds, GSF (the closed-end fund's ticker symbol) can call itself a U.S. government fund as long as it keeps two-thirds of its assets in U.S. government securities, and the Dreyfus funds can call themselves investment grade as long as two-thirds of their assets are rated at least triple-B. In each case, the balance of the fund can be just about anything. So if you want a conservative bond fund or one that holds only investment-grade securities, you've got to find out what the fund allows itself to do with the remaining third of its assets.

The Dreyfus funds can and do buy some very risky, highly volatile emerging-market bonds with their 35% below-investment-grade allocation, judging by their latest filings. GSF, for its part, buys mainly emerging-market bonds with its unregulated funds. Why did you think it was a conservative fund? If a broker sold it to you as one, you've got at least a grievance. If you just assumed it was, you're going to have to be more careful in the future.

Be especially careful with closed-end funds. As this column has previously discussed, the closed-end structure makes most sense for illiquid assets like high-yield and emerging-market debt and municipal bonds. An open-end fund has to sell those assets, possibly at unfavorable prices, to meet redemptions. There's no point in putting only liquid assets such as Treasury bonds in a closed-end fund, which is why there are so few U.S. government closed-end funds (and half of them are other Alliance funds with makeup's similar to GSF's). By contrast, you won't find many (if any) open-end U.S. government funds holding emerging-market debt.

In addition to owning a big chunk of emerging-market debt, GSF is leveraged, meaning that it invests some borrowed money. In general, leverage improves a closed-end fund's performance when bonds are doing well, and worsens it when bonds are doing poorly. This year, bonds have done poorly as interest rates have risen. Thus, the fund suffered a $93 million loss on "investments, options written, swap contracts and foreign currency transactions." All but $1 million of that loss was on primary investments rather than derivatives.

Beyond reading a fund's prospectus or annual report to find out what it can invest in, it pays to ask how the fund performed in its best and worst quarters over the last five years. This should give you a sense of how much volatility to expect. According to Lipper, GSF's best calendar quarter in the last five years was the second quarter of 1995, when it returned 15.5%. Its worst was the third quarter of last year, when it lost 9.15%. (Its second-worst quarter in the past five years was the last of 1994, when it lost 6.02%.)

Over time, GSF has walloped the average open-end U.S. government fund, returning 125.21% vs. 98.38% for the average government fund. It's worth noting, though, that the best performing retail government fund, the no-load (STVSX)Strong Government Securities, returned 122.22% over that period without using leverage, and it never lost more than 2.50% in a calendar quarter. Unfortunately, it isn't clear that GSF is giving you anything you couldn't get from a much less risky product, especially if what you really want is exposure only to highly rated government bonds.

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