The Plunging Schwab Bond Funds

As you might have heard, the largest bond fund at Charles Schwab, YieldPlus, is plunging in price. Suffering from massive redemptions, of the vast majority of its assets, it was forced to sell illiquid mortgage-backed securities at distressed fire-sale prices. As a result, the fund cratered from $8.79 at the end of February to $7.17 at the end of March - a fall of more than 18% in one month - and is now trading at just $6.85. That's a really nasty year-to-date loss of 24% for an ultrashort bond fund which opened the year at $9.01 a share. Here's what it was meant to do:

Investment Goal and Strategy
Seeks to provide a higher yield, with a higher related risk, than a money market fund, and relatively less risk than a longer-term bond fund.

That's the kind of fund where you get angry if it breaks the buck: you expect a bit more volatility than in a money market fund, but you don't expect to lose money outright. And you certainly don't expect to lose a quarter of your investment.

But what we're seeing here is, essentially, a run on the bank; if a fund holds illiquid securities in the present market and is forced to sell them, then one can understand how such losses could appear. More puzzling is the drop in Schwab's Short-Term Bond Market Fund, which, spokesman David Weiskopf tells me, has not been suffering from net redemptions. But it, too, is down sharply, for a fund which is really never meant to fall much in value: it ended February at $10 a share, and ended March at $9.60; it's since slipped further to $9.51.

The two funds are very different. YieldPlus has much more credit, and much shorter duration; the Short-Term fund, by contrast, is mainly invested in Treasuries and invests in bonds maturing as far out as five years from now.

Nevertheless, the problem, according to Weiskopf, is that there was some overlap in the securities held by the two funds; they were managed by the same person. When YieldPlus was forced to sell its illiquid holdings, the Short-Term fund had to mark to those distressed sales. In other words, the fall in the price of the Short-Term fund reflects unrealized losses, while the fall in the price of the YieldPlus fund reflects realized losses.

Weiskopf tells me that Schwab is working furiously on getting its quarter-end figures together in the next few days, at which point it will be able to release accurate figures on redemptions in the two funds. But given that the redemptions in YieldPlus must stop at some point, if only because there's precious little left in the fund to redeem, then eventually the Short-Term fund will start marking not to distressed sales but rather to the normal market again.

So if you own shares in the Short-Term Bond Market Fund, it might well be seeing something of a bottom right now, and could bounce back once the selling over at YieldPlus abates. On the other hand, if redemptions start hitting the Short-Term fund as well, then it too could suffer the fate of YieldPlus and go much lower than it is right now. Either way, neither of these two funds is behaving remotely like the safe haven that one expects short-term bond funds to be. And I'm not at all surprised that Schwab is facing class-action suits right now.