Counterparty Risk in Large Total-Return Funds
We can add another to the list of concerns facing advisors: counterparty risk – a potential loss from the failure of a bank or broker-dealer. Underscoring this threat, DoubleLine’s founder and chief investment officer, Jeffrey Gundlach, recently warned advisors to avoid all funds with counterparty risk. Heeding his warning, however, is not easy; it is virtually impossible to gauge the extent of counterparty risk in most funds.
Counterparty risk is the possibility that the broker or bank with which a fund transacts will fail to live up to its contractual obligations, usually because it is insolvent and faces bankruptcy. Firms that transacted with Lehman prior to its 2008 bankruptcy, for example, suffered losses because they had counterparty risk.
Long-only mutual funds and ETFs that hold individual securities – either stocks or bonds – have no counterparty risk. But more complex funds, including many of the total-return funds that compete with DoubleLine’s Total Return Bond Fund (DBLTX), have counterparty risk to varying degrees.
Those funds hold derivatives, such as credit-default swaps (CDS) and interest-rate swaps, in order to gain exposure to certain segments of the market. A CDS is a promise by a bank (the counterparty) to pay a specified amount in the event that another entity defaults. But the CDS is only as good as the counterparty’s ability to fulfill its obligation.
Gundlach’s made his comments about counterparty risk several weeks ago, when the European debt crisis was worsening and investors had become particularly concerned about France. Those fears have not abated, and it is not hard to see how events in Europe could affect US mutual fund holders.
A Greek default followed by restructurings in other weak European countries would force banks to write off bad loans. As Gluskin Sheff’s Dave Rosenberg reported last Thursday, French banks have assumed a 20% write-off on their Greek debt holdings, but Moody’s, in deciding to downgrade those banks, assumed a 60% write off. Such a write-off could trigger a contagion that could result in the failure of US banks or brokerage firms with exposure to European sovereign or bank debt.
And when a rogue trader can lose $2 billion, as happened recently at UBS, it may not take a sovereign default to drive a firm into bankruptcy.