Tell Me Why

The plights of hedgefunds such as Carlyle Capital and firms such as Thornburg Mortgage are rattling the market. News that hedge funds are closing and Thornburg is teetering on the precipice of insolvency, in spite of the fact that the mortgage securities they hold are legitimately of high quality. The problems are two fold, leverage and volatility.

First, volatility in the MBS market has caused prices to decline of even high-quality MBS as buyers have vacated the market. Some investors remain unsure if they are truly buying high-quality securities. No one wants to catch a falling knife. Opportunists are exploiting the situation. Funds, such as PIMCO are buying the seized assets at fire sale prices as hedge funds' brokers (major Wall Street Firms) force sales to meet margin calls.

Secondly, leverage comes into play. To enhance returns, hedge funds borrow money (lever) to purchase more securities. As bids dry up for MBS and ABS, mark-to-market prices fall. Banks and brokers, which are experiencing liquidity problems themselves, cannot or will not extend more credit to hedge funds and other leveraged investors.

Many hedge fund and closed end funds do not realized they are leveraged. The average small investors does know what leverage is. As I asked with enhanced money funds: How did you think these funds earned such stellar returns when bond yields were so low, through creative bond trading?

Although, it is true that these leveraged funds have some brilliant traders and strategists, the main reason they were able to earn, in some cases, double digit returns and very low yield bond environments was due the increased market participation afforded by leverage. In fact, cheap borrowing fostered by the Fed induced easy money days of a few years ago made leveraged strategies that much more profitable. Now that liquidity is expensive or non-existent, these funds are imploding.

I would like to end with this thought. Bond funds can be very lucrative, but they are not bonds. Investors looking for reliable income and return of principal at maturity should purchase a portfolio of appropriate, actual bonds instead of leveraged bond funds.