Friday, June 8, 2012

Oppenheimer Fined for Complex Derivatives in Bond Funds

By Geng Deng, PhD and Tim Husson, PhD

In May 2010, SCLG released a paper on the Oppenheimer Champion Income Fund, detailing the complex derivatives transactions that led that fund to accumulate huge losses in 2008 compared to other high-yield bond funds.  On Wednesday, the SEC charged OppenheimerFunds for material misrepresentations of these very risks in two funds, including the Champion Income Fund.  OppenheimerFunds agreed to pay $35 million to settle the SEC's claims.

The funds, the Oppenheimer Champion Income Fund and the Oppenheimer Core Bond Fund, used complex derivatives to leverage exposure to the commercial mortgage market.  From the SEC release:
The SEC’s investigation found that the Champion fund’s 2008 prospectus was materially misleading in describing the fund’s “main” investments in high-yield bonds without adequately disclosing the fund’s practice of assuming substantial leverage on top of those investments. While the prospectus disclosed that the fund “invested” in “swaps” and other derivatives “to try to enhance income or to try to manage investment risk,” it did not adequately disclose that the fund could use derivatives to such an extent that the fund’s total investment exposure could far exceed the value of its portfolio securities and, therefore, that its investment returns could depend primarily upon the performance of bonds that it did not own.
In our paper, we explain that the leverage was derived from total return and credit default swaps, which are highly complex securities that involve substantial risks.  The fund's credit default swap holdings, for example, had a notional value of over 70% of the fund's net asset value in early 2008, while the fund did not report any CDS holdings at all.  If the fund's total return and credit default swaps are excluded the Champion Income Fund performed much more closely to its peer group:

Even in 'traditional' fund classes such as high-yield bond funds, managers use complex investments which can involve substantial undisclosed risks. The SEC’s actions here demonstrate the need for complete and accurate disclosures of all derivatives-related risk.

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