As the eurozone was flirting with collapse last year, few investors had the stomach for making big bets there. Observers speculated that peripheral countries would soon default on their debts, that the euro currency would collapse and that stronger members of the European Union would see years of recession in the wake.
Managers at the Legg Mason Brandywine Global Opportunities Bond, however, had a different take. When European Central Bank Chairman Mario Draghi announced plans to buy debt of the peripheral countries if needed to shore up the stronger countries' economies, the managers at Brandywine knew that there would be a payoff for the risk.
In they went, buying up 30-year bonds in Italy and 10-year notes in Portugal and Ireland - although they shied away from Greece, believing those bonds were truly distressed, not just troubled. "We believed [Draghi], and so did a lot of market participants as yields fell," Brian Hess, one of the fund's four managers, says now. "The ECB never had to buy a single bond, but it eased credit conditions within the eurozone."
Prices on the 30-year Italian bonds, which had yielded 6.25%, have rebounded - by early May, the bonds yielded 4.66%. Prices rose elsewhere, too: The yield on Portugal's 10-year bonds, which leapt to 8.25%, fell to 5.6%, and Ireland's 10-year bond yield sank to 3.5% from 6%.
"We're still holding on to these bonds, but the big part of the move is done," Hess says, adding that he believes the yields could still come down another half or full percentage point. "Then you've got the problem of what do you do with the proceeds if you sell them?"
HUNTING FOR VALUE
The European bonds are just one example of the Brandywine fund's top-down calls: The Philadelphia firm makes big, sweeping economic judgments about the direction of fiscal policy or a particular country's well-being, then goes shopping for value in either bonds or currency.
At any given time, the fund managers follow 40 markets, although they actively invest in only 12 to 14. They look for one of three drivers of returns: income, capital gains or currency appreciation.
Rarely does the fund mirror the Citi World Government Bond Index, its closest match. In fact, Hess says, bond indexes are flawed by nature, rewarding countries with big debt loads and overvalued currencies. As debt increases and currency value rises, they become an even bigger weighting in the index.
The managers prefer a price-conscious approach, looking at areas where others don't tread and where countries are experiencing improving fundamentals.
The independent streak has served the fund well. For the 12 months ended May 6, the fund is up an average of 10.9% a year annualized, in the top 9% of the world bond category. Over the three-year time frame, its average 11.4% annualized return lands it in the category's top 1%. (The fund's Class A shares dates back only to 2010, although the institutional shares, with a $1million minimum, launched in 2006.)
The managers say picking winners now has become more challenging than in the past few years. "The number of opportunities has definitely diminished," Hess says, "and we're not getting as much volatility as we used to." The volatility is coveted because it allows for periodic mispricings - and the chance to pounce on a bargain.
Like other bond managers, Hess - who joined Brandywine in 2003, shortly after completing dual degrees in economics and politics at Ursinus College - doesn't see much value in U.S. Treasury bonds. "We are like every fixed-income manager in that we're faced with the challenge of dealing with these very low yields," he says.
But U.S. currency is a different matter. Although the managers tend to prefer the developing markets, which have lower deficits and better growth, the largest allocation in the fund currently is to the U.S. dollar. The fund has 36% parked there, Hess says, because he and his three co-managers see growth rising and "things are improving on a rate-of-change basis," he says.
The automatic spending cuts, or sequester, that went into effect on March 1 are having a desirable effect, he says, in bringing the U.S. balance sheet in line - and the real estate recovery and steady employment gains also bode well for the economy. "As the economy gets further and further away from recession, the budget is improving," Hess says.
Other developed markets are less interesting for him. "As we look at the major currencies, the G3 currencies" - the dollar, the euro and the yen - "we favor the U.S. economy."
SOUTH OF THE BORDER
Another hot spot for the fund is Mexico - which, Hess says, is like South Africa, Brazil and Hungary in possessing those three drivers of growth. The fund has 15% of its assets allocated to Mexico, spread between long-duration and shorter-duration bonds.
A number of positive factors led the team south, Hess says. The Mexican economy is expanding, with growth of 3.9% in 2012. Also, because 85% of Mexican exports head north across the border, the country's economy should get a boost with the U.S. economy picking up.
Finally, the new president, Enrique Pena Nieto, has undertaken a number of reforms - including some in the telecom and energy industries - that Hess believes will ultimately benefit the economy.
In 2011, the team bought 20- and 25-year bonds yielding 8.25%, which are now yielding 5% as prices surged.
GIVING JAPAN A MISS
There's one notable blank spot on the Brandywine map: Japan. The managers sold out of both the Japanese yen, which makes up 30% of the Citi index, and bonds in the second half of 2008. "The currency got so high that it was killing the export sector," Hess says. "We were hearing from Canon, Sony, Toyota how hard it was."
Although the yen has weakened lately against the dollar, the managers believe it compared unfavorably with the weaker Korean won (which the fund did hold, although it's been selling recently); firms like Samsung, Hyundai and LG were surging with the favorable currency at their backs. And Japan's demographics - a shrinking labor force and a growing older population - were also worrisome; revenues appeared to be set to decline just as they were most needed to support the older generation.
"There was very little investment merit, whether you looked at the bonds or the currency," Hess says.
The team was wrong, for a while. The yen continued to appreciate and only began its recent slide at the end of 2012. Since November, however, the yen is down 25% against the dollar, giving exporters much needed relief and breathing new life into the Japanese equity market. In fact, Japan is the top-performing international market in 2013.
For now, Hess says, Brandywine managers' eyes are glued to Japan, waiting for that currency to depreciate further before committing any money. Yet it may be a long wait.
"It's unlikely we're moving back into Japan any time soon," Hess says.
Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times,Money and Kiplinger's.
Legg Mason Brandywine Global Opportunities Bond
Credentials: B.A., economics and politics, Ursinus College
Experience: Associate portfolio manager, Legg Mason Brandywine Global Opportunities Bond fund (2012-present); senior research analyst, Brandywine Global Fixed Income team (2003-present); trading assistant, Bear Stearns (2002-2003)
Inception of fund: March 2010
Style: World bond
AUM: $3.3 billion
1- and 3-year performance as of May 6: 10.89%, 11.39%
Expense ratio: 0.92%
Front load: 4.25%
Minimum investment: $1,000
Alpha: 7.40 vs. Citi World Global Bond Index Non-U.S. Dollar