The San Francisco Chronicle is reporting Higher-yield bond funds run into trouble.

In one of the more spectacular meltdowns in mutual fund history, Schwab YieldPlus – marketed as a higher-yielding alternative to money market funds – has plummeted to just $2.5 billion in assets from more than $13 billion in May.

The shrinkage reflects both a decline in the fund’s asset value and a mass exodus by investors.

Year to date through Thursday, Schwab YieldPlus has lost 13.4 percent of its value, ranking dead last among ultra-short bond funds, according to Morningstar. The average fund in that category is down 1.5 percent this year.

A decline of that magnitude would not be unusual for a stock fund but is rare for a fixed-income fund, especially one that invests in short-term securities.

Schwab won’t discuss the fund in any detail, in part because it is the subject of two class-action lawsuits.

It’s not entirely clear what happened, but experts say that when the fund started to lose value last year, investors who thought they owned something resembling a money market fund started pulling out their money.

To meet redemptions, the fund had to sell assets into a declining market, which caused more losses, which sparked more redemptions in a wicked downward spiral.

Ultra-short bond funds get a slightly higher yield than money funds by investing in slightly longer-term, slightly lower-quality securities.

Schwab advertised the fund on its Web site as “a smart alternative for your cash.” Schwab made it clear that YieldPlus is not a money market fund, is not insured and could lose value.

But it also said the fund’s share price had fluctuated by no more than 4 cents over the year ending Jan. 31, 2007, “giving it the relative stability necessary in today’s market.”

A look at some ultra-short bond funds that have struggled, compared with the category average. Returns through Thursday.

Anyone chasing high yield junk seeking extra income needs to think twice.

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Words To Avoid

  • High Yield
  • Yield Plus
  • Structured
  • SIV
  • VIE
  • Enhanced
  • “Almost” Like Cash
  • Toggle
  • Junk
  • Vehicle
  • Leveraged

Those in or thinking about getting into any product that uses those words may wish to reconsider.

Furthermore, when it comes to funds or products that use the word “Government”, make sure the fund invests in genuine government backed securities such as US treasuries or Ginnie Mae securities not agency debt like Fannie Mae or Freddie Mac.

Mike “Mish” Shedlock
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