Mutual Funds for the Utterly Confused

As we continue to look at the risks that face mutual fund shareholders, issuer risk and leverage risk can play an important role in how we assess what we want in an investment. But first, let’s take a look at what these types of risks are and how you may not be able to avoid them altogether.

Issuer risk deals primarily with fixed income securities.
An issuer, who pays the coupon or the interest payment on the bond holding is rated by a rating agency. That rating helps investors determine the ability of the issuer to pay back the loan. If they are highly regarded, the bond will offer little in the way of interest on the investment because the risk is low. On the flip side, if the credit rating the issuer has received is low, the interest rate will be higher because the risk the issuer might not be able pay in full are greater. The reward for risk is interest rates. Low risk equals low return rates; high risk cost the issuer more to attract investors.

There was a great deal of discussion among the quantitative guys on how to assess risk in these types of situations. If the portfolio was plain vanilla with determinable maturities and easily assessable risk factors, an issuer risk number would be relatively straightforward. But these financial instruments have gotten so complicated that who owes what and when is often not known unitl is is too late for the investor. The mortgage meltdown is grounded in issuer risk.

Leverage risk is not altogether different than issuer risk except it is you, the investor who is the risky party.
Okay, you the investor as a mutual fund manager. Leverage is best described as the ability to secure a loan with the underlying asset as collateral. Much like your house. If you were to miss a payment, the home would be taken away despite the amount of payments you may have already made.

Stocks work the same way. There are times when a mutual fund charter may allow the manager to buy stocks with margin. This is essentially borrowing the stock with the promise to pay an agreed upon price. If it goes down, you are liable for the cost. If it goes up, you pay off the broker and sock away your profit on the transaction.

It is only leverage risk when things go bad in the markets and you (or in this instance, your fund manager) have to cover your losses with the sale of stock or worse, cash. It is only issuer risk when the borrower fails to make payments to you. Both of these types of risk can pose out-sized risk but in some cases, it might be unavoidable.

Next up: management risk