Subprime-mortgage losses drop bond fund behind rival

Fidelity Investments' Inflation-Protected Bond Fund is lagging behind its biggest competitor, a Vanguard Group Inc. fund, after losses in subprime mortgages, this year's worst-performing debt market.

The $1.25 billion mutual fund, run by William Irving in Merrimack, N.H., rose 3.2 percent this year, trailing the 3.8 percent gain of the Vanguard Inflation-Protected Securities Fund, which holds no mortgage bonds. The Fidelity fund advanced at an annual rate of 5.6 percent during the last five years, compared with the 6 percent return of the $10.2 billion Vanguard fund, data compiled by Bloomberg show.

Fidelity's fund has disappointed investors as defaults on home loans to people with limited credit rose to the highest level in a decade. The ABX-HE-BBB-06-1 index, tied to mortgage-backed bonds with the lowest investment-grade ratings, fell more than 60 percent this year, according to London-based Markit Group Ltd.

"Someone who's investing in lower-quality securities to help performance, even to a limited extent like the Fidelity fund, is taking a chance," said Paul Herbert, an analyst at Chicago-based research firm Morningstar Inc.

The fund, which attempts to provide returns that exceed the rate of inflation by buying Treasury inflation-protected securities, or TIPS, had 0.5 percent of assets in derivatives linked to subprime loans, according to Morningstar. It also was hurt because 18 percent of its assets were in the Fidelity Ultra-Short Central fund, another subprime holder.

Irving's fund lost Morningstar's four-star rating July 3, and it now has three stars out of a possible five. Its minus 0.08 Sharpe ratio, another measure of risk-adjusted returns, compares with the minus 0.16 three-year average for its peers.

The Vanguard Inflation-Protected Securities Fund holds only TIPS or other Treasury securities, comanager Kenneth Volpert said. It returned 4.49 percent in the last 12 months, more than the 3.63 percent average of those that invest in TIPS, according to data compiled by Morningstar.

"Our investors value the simplicity and purity of the fund," Volpert, 47, said. Vanguard, which is based in Valley Forge, is the second-largest mutual fund company, after Fidelity.

The Fidelity fund rose 3.87 percent in the last year, Morningstar data show. It gained at an annual rate of 3.75 percent over the last three years, beating the 3.39 percent average of its rivals.

Late payments for subprime home loans rose to almost 13.8 percent in the first quarter, five times the rate for so-called prime loans to creditworthy borrowers, according to a June 14 study from the Mortgage Bankers Association in Washington.

Irving, 43, has a doctorate in electrical engineering from the Massachusetts Institute of Technology in Cambridge. He has run the Fidelity fund for the last three years.

He used credit-default swaps to wager that the price of insuring $6.7 million of bonds backed by subprime mortgages against default would decline, according to the fund's annual report dated April 30.

"The fund had a very modest amount of its assets invested in subprime-mortgage securities," said Sophie Launay, a spokeswoman at Boston-based Fidelity. Irving declined to comment.

In a credit-default swap, an investor buys or sells insurance on a bond. As a seller, the Fidelity fund got a fixed payment in return for making later payments if the bonds default. If the perceived risk of default rises, the seller's contract loses value.

The 14 credit-default swaps in the Fidelity Inflation-Protected Bond Fund reduced returns, according to the annual report.

"Out-of-index holdings in asset-backed securities backed by subprime-mortgage loans came under pressure due to concerns about subprime-mortgage delinquencies and the growing likelihood of an increasing default rate," Irving said in a report on Fidelity's Web site.

TIPS pay interest at a lower rate than Treasury notes, and their face amount is linked to the Labor Department's Consumer Price Index. The 10-year TIPS issued in January that pays interest at 23/8 percent made its first semiannual payment July 15 on a principal amount of $1,027.73. The 10-year Treasury note sold in February pays interest at a 4.625 percent rate on a $1,000 principal amount.

Some inflation-protected bond funds invest in other securities, because the TIPS market consists of 24 bonds with a combined value of $437 billion, limiting a manager's choices, said Herbert, the Morningstar analyst. Managers also seek higher returns with lower-rated securities.

Of the six funds monitored by Morningstar, only Fidelity's ventured into subprime mortgages, he said.

Fund company: Fidelity.

Manager: William Irving.

Assets: $1.25 billion.

Performance: Up 3.2 percent in 2007.

Holdings: Treasury bonds, mortgage bonds, corporate bonds.

Ticker: FINPX.

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