Oppenheimer Bond Funds Missed the Forest Fire for the Trees

The latest news is that fund manager Angelo Manioudakis decided to leave Oppenheimer. The firm announced it Monday, and, according to its director of fixed income, Jerry Webman, the decision was in fact all Angelo's. (Webman is also the firm's chief economist and a senior investment officer.) Oppenheimer has by all appearances stood behind Manioudakis, who came from Morgan Stanley in 2002 and before that the well-respected Miller, Anderson & Sherrerd, which Morgan acquired several years earlier. In fact, Oppenheimer even pumped $150 million of its own money into  Oppenheimer Champion Income (which Manioudakis and team run) during the height of the crisis, and the team appears to have remained steadfast in its determination to see through the strategies and positions that have thus far scalded most of the portfolios for which they're responsible.

It's not hard to imagine why Manioudakis felt like throwing in the towel. For the year to date,  Oppenheimer U.S. Government Trust was down 5% as of Monday (Dec. 15, 2008), and  Oppenheimer Limited-Term Government was down 7.8%--losses made all the more painful for investors watching competitor portfolios turn in returns north of 3% as Treasury bonds provided one of the market's only bright spots. Those were mere flesh wounds when compared with what happened at  Oppenheimer Core Bond and Oppenheimer Champion Income (the firm's main high-yield offering). The former is off 38.5% through Monday, and the latter an absolutely nauseating 80.1%. Even with 2008's ugly market, we don't need any benchmarks to know that neither are anywhere near the market averages.

Bad Markets, Bad Returns
At first blush, the cause seems logical enough. Manioudakis and his team tried to keep powder dry in mid-2007, figuring that good opportunities were going to present themselves. By January 2008, the team had begun packing some of that powder, building positions in four key areas that they felt had become exceedingly cheap. That included AAA rated commercial mortgage-backed securities, nonagency prime (jumbo) mortgages, AA and A rated financial-sector corporate bonds, and very short-maturity high-yield corporates. As we all know by now, the market only got worse and became more illiquid through the course of the year. Each of those areas has been pummeled mercilessly.

Something just didn't add up for us, though. In January, Manioudakis told Morningstar that CMBS consumed 10% of the Core Bond Fund's "absolute market value." But as badly as the sector performed--The Barclays (nee Lehman) CMBS Index fell 27.4%--that alone couldn't possibly explain the portfolio's overall loss of nearly 39% as of Monday. Ditto for the other sectors, even though they lost a lot, as well.

Not 10 ... This One Goes to 11
We had some suspicions about the portfolios' exposures, which weren't confirmed for us by Oppenheimer until now. It turns out that when Manioudakis and the crew decided that the four areas they identified were undervalued, they really decided.

By the end of March, the Core portfolio carried around $400 million in securities exceeding its (then) $2.2 billion in net assets via transactions that were effectively akin to margin borrowing. It also had roughly $800 million in long exposure to corporate credit via default swaps--including  American International Group , Lehman Brothers,  Wachovia , Washington Mutual, and Bear Stearns--and around $600 million in total return swap exposure to a volatile slice of Barclays' AAA rated CMBS index, all of which by normal reporting convention were not included on the fund's balance sheet and thus not in its net assets. By the end of September, just before the Treasury Department's Troubled Asset Relief Program proposal and right around the time the market sailed off into uncharted mania, Core Bond's credit exposure to those various markets totaled more than 180% of net assets on a dollar basis. In other words, for every dollar of shareholder capital in the fund, it was exposed to the credit-driven movement of more than $1.80 worth of securities.

To be fair, it is a little more involved than that. Some of the fund's swaps, for example, saw their weightings rise as the CMBS market fell because of the way that swaps work and the fact that illiquid markets and stumbling dealers made them nearly impossible to sell or hedge. And although less meaningful in some ways, given that so few sectors traded in sync with the white-hot Treasury bond market in 2008, the fund's swaps (including its total-return swap contracts) provide exposure only to the market's credit-driven movements, not its interest-rate gyrations. The message here isn't that derivatives are bad, though they can obviously be dangerous if not well understood. Rather, there is just no getting around the fact that the extra layers of market exposure were piled high.

I'm Sorry, I Couldn't Hear That. Would You Speak Up?
Left there, things would have been plenty bad enough. But they weren't. Because most of the additional market exposure came from off-balance-sheet derivatives, the funds' portfolios didn't look highly leveraged. And while they may have been only somewhat leveraged in what we might call a conventional accounting sense--by borrowing money against your net assets and investing it--they were heavily leveraged as mutual funds go, in an economic sense. Because of the former, it doesn't appear that the funds violated any regulations or compliance requirements. And because the managers were careful to control interest-rate risk, in part through futures and swaps, and in part by taking on only credit exposure with their off-balance-sheet derivatives, they may not have really thought of their funds as heavily leveraged.

To the degree it existed, that thinking was erroneous, and it's very disappointing that the team didn't internalize just how much risk it was taking. The comparison feels almost unkind, given anecdotes suggesting that ratings agencies assumed no housing losses whatsoever, but there's an analogy between how the agencies assessed subprime loans and what was done here. By using modeling assumptions from observed volatility and loss experience--in the funds' case with CMBS, for example--both failed to model or plan for the possibility of severe downturns and thus for how they could turn the equivalent of a discarded cigarette into a raging inferno.

The only thing worse than levering up a portfolio with 180% market exposure, though, is doing it quietly. I'd like to be wrong about this, but I can't imagine that the average shareholder or advisor with a stake in these funds knew that they were leveraged in any way. The word itself doesn't seem to be linked to any of the funds' strategies anywhere I've searched on Oppenheimer's Web site or in any of the supporting shareholder or marketing materials that we've seen. Terminology aside, none of the portfolio descriptors provides enough information to estimate those market exposures, much less know that they're not typical, 100 cents in, 100 cents invested. There's just no indication whatsoever that anything is unusual about any of the funds that employ this kind of leveraged exposure. And it was never brought up by Oppenheimer managers in any of their recent Morningstar analyst interviews.

Get Out Your Number-Two Pencils, Please
The only clearly identifiable way to figure it out is to examine the funds' SEC filings and meticulously calculate cash bond, swap, futures, and total-return swap exposures (and maybe others depending on the portfolio) for each fund. I say meticulously because some of them offset each other, while others carry cryptic language to describe their payment streams that borders on indecipherable. When I first came up with an approximate market exposure of 186% for Core Bond, I smirked and figured that I needed more sleep. Even then I was reluctant to tell anyone about it; I was sure I had misread a label or screwed up the computation. We engaged a handful of people to look over our work in examining the portfolios, but we still only felt comfortable that our conclusions were accurate after speaking with Oppenheimer.

How is it possible that a shareholder can go to its Web site, see that Core Bond is down nearly 40%, or 80% in the case of Champion Income, and yet find no information to use to figure out why, much less an actual explanation? Both of Oppenheimer's U.S. government funds held significant CMBS exposure in their latest shareholder reports, and the U.S. Government Trust had swaps-based economic leverage, as well. The funds' manager letters mention CMBS, but concrete data about the magnitude of those exposures can only be derived through the arduous process described above.

I'm sorry to be glib, but this strains credulity. Here's a news flash, Oppenheimer: If your funds are going to use instruments that involve this much portfolio complexity, you have a duty to translate and simplify what that means for your shareholders. Not doing so is patently unacceptable and comes awfully close to dishonesty by omission. While most of your competitors haven't taken on anywhere near this much risk, many use similar portfolio techniques and are just as guilty of these omissions. I can think of numerous ways this can all happen without intent, but we're way past the honeymoon period now that these tools have been around for quite a while. It's time for this to stop all around.

They're Not the Usual Suspects
Manioudakis' boss (until this week), fixed-income chief Jerry Webman, makes a thoughtful point when he argues that the team's decisions weren't made recklessly, or without regard to risk. As Webman sees it, it wasn't as though Manioudakis intended to make one huge bet and just let it ride--the proverbial "Dealer, please put it all on red" scenario. Rather, he sought to capitalize on what appeared to be historically unthinkable valuation opportunities that nobody expected to act in any correlated fashion. As Webman puts it, everyone anticipated that the positions would to some extent offset one another's risk profile. And frankly, if you read the funds' shareholder reports, it all sounds so compellingly logical. Like many others on Wall Street, the team had evaluated those exposures, or "stress tested" them, based on what had previously been rare market scenarios but that proved quaint next to the price movements that actually occurred and which represented market fear of true economic calamity.

This story is a tad atypical in that fund blowups often occur at places, and with managers, about whom we've long had a wary view of some magnitude. It's not always possible to see them coming, but they are often not surprising given prior signs of weak stewardship or unimpressive management. But while Oppenheimer as a whole hasn't generally distinguished itself, and not each of Manioudakis' offerings was a winner, Core Bond had actually been stellar under his leadership through 2006, and he had a good reputation in the industry. The fund's remaining managers have said that they hold significant sums of money in their funds today. That should provide some comfort to investors considering riding out this crisis in the hope that the managers' conviction--that these don't all have to be permanent losses--will be vindicated. Meanwhile, our conversation with Webman this week seemed only to confirm our long-held impressions of him as a straight shooter.

In hindsight, it seems that Manioudakis and his crew were overly focused on trees that appeared to be incredible bargains. They backed up all of their trucks and even used a few of their neighbors'. Sadly, it seems that they couldn't see that the forest was on fire.

Mutual Fund Analyst Miriam Sjoblom contributed to this article.