After years of flying high, Jim Kelsoe's bond funds have lost half their value this year. By Andrew Tanzer, Senior Associate Editor December 1, 2007 For years, bond funds run by Morgan Keegan's Jim Kelsoe soared. Then, like Icarus, Kelsoe strayed too close to the sun and came crashing back to earth with melting wings.Kelsoe's losses so far in 2007 have been stunning. Regions Morgan Keegan Select High Income (symbol MKHIX) plummeted 56% through December 5, and Regions Morgan Keegan Select Intermediate Bond (MKIBX) collapsed 45%. Results of four closed-end Morgan Keegan fixed-income funds also managed by Kelsoe have also been disastrous. Sponsored Content To top it off, an Indiana charity has filed an arbitration complaint against Morgan Keegan for alleged misrepresentation of risk of the Regions MK Select Intermediate Bond fund, which, on the surface, seems to be a plain-vanilla, low-risk bond fund. Until this year, Kelsoe, the chief-fixed income investment officer of the Memphis-based brokerage's Morgan Asset Management, posted outstanding results. For example, from 2000 through 2005, Regions MK High Income landed in the top 1% of high-yield bond funds every year but 2003, according to Morningstar. Advertisement What happened? Two separate but related factors crushed Kelsoe's funds. First, reaching for yield, he allocated a large chunk of his funds to exotic and illiquid asset-backed securities (and relatively little to standard high-yield corporate bonds) that have been devastated by the earthquake in credit markets this year. For example, as of June 30, 45% of Intermediate Bond's assets was invested in collateralized debt obligations and home-equity loans. He also stuffed his portfolios with airline leasing obligations, which have suddenly been buffeted by market turbulence this year. So the values of his funds' assets plunged. Second, and equally devastating, was the rising tide of shareholder redemptions, which forced Kelsoe to sell illiquid assets (investments that are not readily marketable) at the worst possible time. In both July and August, for instance, shareholders yanked more than $100 million out of High Income, which at last word held $291 million in assets. Advertisement "Investors get their statements in the mail, see the losses, panic and sell," says Lawrence Jones, a bond-fund analyst at Morningstar. "This forces a fund manager to liquidate segments of a portfolio in an uncertain, illiquid marketplace at prices that will be absolute bargain basement. This is a case study that illustrates what can happen in illiquid markets when redemptions come." For example, Jones says, there are only a handful of trading desks in the country that handle airline lease-related securities. Assets such as these will recover when markets stabilize, but that's of little consolation to a fund manager forced to sell today because of shareholders running to the exits. With the benefit of hindsight, it's clear that illiquid assets such as these are ill suited to open-end funds, which are subject to abrupt and mass redemptions. Kelsoe declined to be interviewed, but he has explained the predicament to his dwindling ranks of customers in letters to shareholders. "In the current market, many of the normal dealers that typically provide the trading liquidity of these securities are no longer providing such liquidity," he wrote in a letter dated November 7. "In many cases where there is no trading activity, bonds fall into a vacuum and are valued based on models projecting future cash flows. There are no optimistic projections at this time!" The Morgan Keegan disaster is a reminder that investors need to undertake a bit more investigation than usual when they contemplate buying into a bond fund that has delivered abnormally high returns. That requires some understanding of the assets the fund holds. In general, you shouldn't invest in what you don't understand. As for Jim Kelsoe, his annus horribilis continues to unfold.