Imagine your financial adviser selling you a bond fund that you thought was invested in low risk index or municipal securities only to find out that much of your holdings are in high-risk Chinese or Puerto Rico bonds.
Unfortunately, that is the situation facing investors who may have unwittingly bought bond funds without realizing they held a large percentage of Chinese bonds, according to a recent Wall Street Journal article.
"From April 1 onward, many investors will start to own Chinese bonds for the first time, making them creditors to the government in Beijing and the state-owned policy banks," the Journal recently reported. "That's because China has been admitted to the Bloomberg Barclay's Global Aggregate Index, which began its life as the Lehman Aggregate Bond Index. It will give many debt investors their first direct exposure to the labyrinthine Chinese market."
"Labyrinthine" is not the type of word most Mom and Pop investors want to use when describing their bond portfolios. Such investments are supposed to be safe and stable, not a maze-like puzzle.
Mutual fund companies that sell funds based on indexes are known as passive investments because they simply track the index. "Hundreds of billions of dollars in passive funds" will likely migrate to Chinese debt over the next couple years, according to the Journal.
Investors are already getting exposure to Chinese companies following the MSCI Inc. decision to add Chinese A-shares into its flagship emerging markets index, according to the Journal.
Investors have seen such a surprise in their bond portfolios before.
When the Puerto Rico bond market collapsed in 2013, many U.S. investors were shocked to learn that they owned a substantial portion of Puerto Rico bonds in their municipal bond funds. For example, the Oppenheimer Rochester Maryland Municipal Fund held more Puerto Rico bonds than Maryland bonds as of 2015, almost 50%!
Riskier bonds offer the potential for higher returns. Maryland's credit rating was AAA, so its low-risk bonds offered just a sliver of a reward. Add higher yielding Puerto Rico bonds to the mix and the yield becomes much more attractive.
The Oppenheimer Virginia Fund was 40% Puerto Rico bonds in 2015 and its North Carolina bond fund had 35% Puerto Rico holdings.
We're not saying that the bond market in China is in any danger of imminent collapse, however, this blog can't stress enough that investors must perform due diligence, even for plain vanilla index or municipal bond funds.
Otherwise, you might have a painful, unpleasant surprise in your portfolio.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.