Waiting for your bond funds to unload those
holdings? Don't hold your breath.
While many bond funds are forbidden to buy debt that's rated junk -- as GM and Ford bonds are after
Thursday's move by rating agency S&P -- managers often have more latitude in how fast they sell after a downgrade. That should make for a more orderly selloff in the companies' debt.
Standard & Poor's cut its ratings on both automakers' bonds to junk Thursday, citing the companies' competitive disadvantages. The cut is significant because it increases the borrowing costs for the big car manufacturers, leaving them even further behind the financial eight-ball.
The cuts mean that mutual funds that hold only investment grade debt will be forced eventually to purge their Ford and GM bonds. Ford and GM will be removed from the Lehman Index, which many funds track, at the end of this month. According to Miller Tabak, $44.9 billion in Ford bonds are slated to fall out of the index at month end and $45.1 billion in GM.
How and when the fund managers intend to do that, however, depends on the guidelines stated in the fund's prospectus.More to the point, most corporate bond funds won't have to dump the bonds immediately.
The $1.4 billion
Thornburg Limited-Term Muni Bond fund, for example, owns a small position in GM Industrial Development Revenue Bonds, which are tax-exempt bonds issued by municipalities and backed by corporate credit. Thornburg Managing Director Steven Bohlin says the fund won't be forced to sell the bonds after the downgrade due to the discretion offered in the fund's prospectus.
"Right now we think the liquidity is adequate to meet its obligations, but any further degradations at GM might warrant selling that position," says Bohlin.
Don Quigley, portfolio manager for the $178 million
Julius Baer Total Return Bond fund, is also limited to buying investment grade bonds. But when that stamp of approval is removed, he has the privilege to sell whenever he wants, as long as it is in a "prudent manner."
"If the bond is maturing tomorrow, then we don't have to sell it today just because of the downgrade," says Quigley. "But if it's a 30-year bond, then selling it today would probably be considered prudent."
Quigley's fund currently holds Ford bonds that are close to maturity. Right now he is evaluating whether he wants to stick with them.
It's also worth noting that Quigley's fund is a global bond fund and Bohlin's fund is a muni fund, two places where bond fund investors might not expect to find Ford or GM bonds. So check your fund's holdings for any Ford or GM issues.
Another thing to search for in a bond fund's prospectus is whether the fund is entitled to hold a certain percentage of noninvestment grade debt.
The $233 million
T. Rowe Price Corporate Income fund allows noninvestment grade debt to comprise up to one third of the fund. Even if a company's debt is dropped from the Lehman index, the fund managers won't be forced to sell.
As of the end of March, the fund held both GM and Ford bonds. But that should not be surprising to fundholders, as junk bonds typically make up roughly 10% of the portfolio, according to fund tracker Morningstar. The fund also invests heavily in BBB-rated issues, which are just one step above junk bonds.