The Hidden Danger Inside Your Portfolio

The crashing stock market has everyone wondering how bad things will get. And even though some diversified portfolios haven't done as badly, many investors have realized that they weren't as diversified as they thought.

If you follow an asset allocation strategy that includes bonds and other non-stock investments, you probably haven't lost as much money as the major market averages. But the damage done by the financial crisis hasn't been limited to stocks. Consider, for instance, this group of companies that one particular mutual fund invested in:

Stock

1-Year Return

Williams Companies (NYSE: WMB  )

(54.6%)

Freeport McMoRan Copper & Gold (NYSE: FCX  )

(66.8%)

Sprint Nextel (NYSE: S  )

(79.1%)

Comcast (Nasdaq: CMCSA  )

(30.5%)

Chesapeake Energy (NYSE: CHK  )

(52%)

Alcatel-Lucent (NYSE: ALU  )

(74.3%)

Xerox (NYSE: XRX  )

(53%)

Source: Yahoo Finance.

You won't be surprised to hear that shareholders of this fund have lost money. What may surprise you, though, is that the fund is the Fidelity Capital & Income Fund (FAGIX) -- a high-yield bond fund that has just 12% of its assets in stocks. So far this year, the fund has dropped more than 20% -- a huge drop for a bond fund.

Nor is Fidelity's fund the only one suffering from the drop in high-yield bonds, also known as junk bonds. Merrill Lynch's index of high-yield debt is off nearly as much as the Fidelity fund. Other large, high-yield funds from companies like American Funds, Vanguard, and PIMCO have seen similar losses.

Aren't bonds safe?
The losses offer a stark reminder to investors that not all bonds are the same. The recent flight to safety in the fixed-income markets reveals the distinctions among different types of bonds -- all too clearly, for high-yield investors.

In the hierarchy of bonds, Treasury bonds are the cream of the crop. With no chance of default -- if the Treasury needs money, it can always print it -- Treasuries create a benchmark against which all other types of debt get measured. Similarly, bonds issued by federal agencies and guaranteed by the Treasury, such as Ginnie Mae mortgage securities, also enjoy high levels of security and relatively low interest rates.

Yet while the high-quality part of the credit markets is important, it's definitely not the only part. Corporations rely on debt financing to run their businesses, but their debt isn't as safe as Treasury bonds. To compensate investors for the added risk, corporate borrowers pay investors higher rates than they can get on Treasuries. The riskier the company, the higher the rate.

Crushed in the stampede to quality
Therein lays the problem. As credit has dried up, investors' appetite for bond-related risk has evaporated with it. The corporate bond market has responded by increasing the amount of extra interest yield above prevailing Treasury rates -- also known as the spread.

On the bright side, some high-yield bond funds currently offer yields above 10% -- well above where they've traded in recent years. But there's little dispute that the risk involved is higher than in the past, so whether even those double-digit yields are enough to compensate for the risk that an issuer will default and leave you with pennies on the dollar is far from clear.

For current junk bond investors, though, prices on existing junk bonds have fallen as spreads and yields have risen. So if you already own junk bonds, either directly or through a mutual fund like Fidelity's, then the losses you're seeing are bigger than you might have thought possible for a fixed-income investment.

Know what you own
The fall in high-yield bonds is just one more reason why you need to stay aware of what you hold in your portfolio. You can't always tell just from the fund name what type of bonds you own, so don't let plummeting market values be your first sign that you've bought something riskier than you realized.

That said, if you realize you own junk bonds that have fallen in value, panic-selling isn't necessarily the right answer. Just as the declines in the stock market have created opportunities, so too can a smart bond-fund manager find good value in bonds. But if you have anything more than a small allocation to junk bonds, you should strongly consider whether cutting your exposure would be more appropriate -- even if you choose to wait until the panic is over to act.

For more on surviving the crash, read about:

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Fool contributor Dan Caplinger has seen his small junk-bond position take a big hit. He owns shares of Chesapeake Energy and Freeport McMoRan. Sprint Nextel and Chesapeake Energy are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy doesn't hold anything back.


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  • Report this Comment On October 10, 2008, at 1:40 PM, mlaursen wrote:

    We've got to stop repeating the old financial dogma that government-backed investments are safe. Government is not a bottom-less well of cash.

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