What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Can a Treasury Bond Mutual Fund Go Bankrupt?

Original post by Victoria Duff of Demand Media

A mutual fund is made up of distinct legal entities, which include the pool of assets, the board of directors and the investment management company and other entities such as a transfer agent. The pool of assets is a separate corporation with its own board of directors and shareholders -- the individuals who invest in the mutual fund. The board of directors hires or fires the investment management company based on its performance managing the pool of assets.

Pool of Assets

The pool of assets includes the money shareholders deposit into their mutual fund accounts and the securities purchased for the fund by the investment manager. In a Treasury bond mutual fund, the investment manager must manage the fund according to the instructions given by the board of directors, which state that the fund is to be invested in U.S. Treasury securities of a certain maturity. For a short-term fund, the securities would be Treasury bills and notes with maturities shorter than 2 years. An intermediate-term Treasury mutual fund would invest in Treasury notes with maturities ranging up to 10 years, and a long-term fund would invest in maturities up to 30 years. There is normally a limit on the amount of cash the fund can hold, which may be as high as 25 percent, and this cash must be invested in repurchase agreements collateralized by Treasury securities or in short-date Treasury bills.

Full Faith and Credit

U.S. Treasury securities carry the full faith and credit guarantee of the U.S. government. This means that the government promises to pay interest and principal in full, in a timely manner. The Treasury can print money to pay all interest and principal, which means default is highly unlikely. For the Treasury securities in the pool of assets to become worthless, forcing the mutual fund into insolvency, something drastic and unprecedented would have to happen to the U.S. government.

Interest Rate Risk

All bonds carry risk, even if they are obligations of the U.S. Treasury. The primary risk that would cause the value of the pooled assets to decline is interest rate or market risk. If market interest rates rise, the dollar value of the bonds in the portfolio declines. This is where the investment managers earn their pay. A skillful investment manager employs strategies to lessen the negative influence of rising interest rates on the dollar value of the portfolio. However, if the investment manager fails to manage properly, the pool of assets still remains intact, though its dollar value may be diminished. Holding the bonds to maturity will return full principal, and interest will continue to pay into the fund semi-annually till maturity. With the asset pool intact, the mutual fund will not be insolvent.

Investment Management Company

The investment management company reports its portfolio management activities to the board of directors and the board of directors reports to the Securities and Exchange Administration under the Investment Company Act of 1940. The investment management company is paid a management fee based on the size of the portfolio of pooled assets, so it has an incentive to manage those assets carefully and to optimize their growth, within the guidelines set forth by the board of directors. The investment management company can become insolvent and be forced to declare bankruptcy because of its own internal financial problems, but its finances do not affect the pooled assets it manages. Those are separate from the investment management company. The board of directors would fire the investment management company and hire a new one. The pool of assets would remain intact.

                   

References

About the Author

Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.

Advertisement