The Wall Street Journal-20080215-Citigroup Leveraged Fund Falls Amid Bond Market-s Volatility

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Citigroup Leveraged Fund Falls Amid Bond Market's Volatility

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As Citigroup Inc. struggled to contain the damage caused by the bond market's meltdown last autumn, its Alternative Investments unit rolled out a leveraged fund that was essentially a bet that the worst was over.

Now investors in the fund are realizing how wrong that bet turned out to be.

The fund, Falcon Plus Strategies, plunged 52% in last year's fourth quarter, according to a letter sent to investors this week. Investors were warned to expect additional losses as the fund tries to dump some of its battered holdings.

For example, Citigroup said the average collateralized debt obligation held by the fund is priced at just 25% of the initial value of the securities, partly because of exposure to subprime mortgages.

"The magnitude of the on-going crisis is significantly outside of our expectations both in terms of velocity and magnitude," Citigroup added in the letter. Citigroup spokesman Jon Diat said, "As with many other credit-based investment products, Falcon's returns have been hurt by one of the most volatile periods for fixed income in recent memory."

Launched Sept. 30, Falcon Plus was designed to generate twice the returns of another Citigroup fixed-income hedge fund called Falcon Strategies Two. The Strategies Two fund was part of a series of funds started in 2006 that use leverage to boost their positions by anywhere from five to seven times their original size.

The funds were supposed to show only small ups and downs in price thanks to diversification across a wide variety of bond-market strategies. Among the markets that Falcon scours for opportunities are mortgage-backed securities, preferred debt and bets that play municipal debt against U.S. Treasurys.

The Falcon funds were sold to institutional investors, such as insurance companies and banks, as well as high-net-worth investors. Reflecting the expectation that the funds would generate steady-as-she goes returns, Citigroup received from Standard & Poor's a volatility rating of S2 for the funds. On S&P's scale of S1 to S6, the S2 rating meant the fund would have "moderate sensitivity" to events in the bond market. S&P didn't issue a rating on the Falcon Plus fund.

Unfortunately for Falcon investors, signs of stabilization that the bond market showed in early October quickly disappeared, and many of the strategies it employed became ground zero for the worst troubles in the bond market.

In addition to their subprime exposure, the funds also ran into trouble in the municipal-bond market, which has been shaken by problems with bond insurers. Among Falcon's bets were that U.S. Treasurys would outperform municipal bonds. But as investors flocked to the safety of U.S. Treasurys -- a trend already in place in September -- the reverse has happened.

The Falcon series of funds was down about 30% last year, according to people familiar with the fund's results. Because of the additional leverage it used, Falcon Plus took an even harder hit during its first three months of operation.

Last month, S&P revised its volatility rating on the Falcon funds, to S5, meaning they "may be exposed to a variety of significant risks."

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David Enrich contributed to this article.