The forecast for the housing market is gloomy. RealtyTrac, the web-based database of foreclosed properties, predicts there will be more bank repossessions in 2011 on top of the record 1.2 million in 2010, sluggish recovery notwithstanding. Estimates call for home prices to keep falling.
Some investors might steer clear of anything to do with mortgages, given these predictions. Not Metropolitan West Total Return bond fund. The three managers of the $11 billion fund find conditions for mortgages optimal.
The firm applies intense research and balance sheet analysis to study bond picks. When circumstances seem least favorable, the Los Angeles-based firm relies on its analysis to discern trash from would-be treasures.
Today, that research points to mortgages as some of the most fertile ground for bond investors. It's certainly not because more bad news won't befall residential real estate. But Tad Rivelle and his co-managers, Laird Landmann and Stephen Kane, think bond prices already reflect creeping foreclosure rates. The upside is substantial, they say. About a third of the fund is in mortgage-related bonds.
By digging deep, managers at MetWest Total Return have been able to turn out impressive performance. For the three years ended Jan. 5, the fund is up 8.4%, in the intermediate-term bond category's top 3%, according to Morningstar. For the five-year span, the fund is up 8% a year annualized, in the category's top 2%.
BOND ROOTS
The MetWest brand of bond acumen is what you might expect from its founders, Rivelle and Landmann, who broke off from Pimco in 1992. Like Pimco superstar Bill Gross, MetWest forms big-picture views of the economy and looks for bonds that can thrive in certain climates.
After a four-year stint with Hotchkiss & Wiley's fixed-income department, the pair set up their own shop in 1996. For 14 years MetWest amassed a strong record of bond management, even picking up a Fixed-Income Manager of the Year award from Morningstar in 2005.
In late 2009, the TCW Group came calling. Rivelle became the firm's CIO, and his team took over the management of TCW's funds. In addition, MetWest brought its own funds, and $30 billion under management.
Rather than blend assets of funds with similar mandates, MetWest manages portfolios under its own label in addition to taking over the TCW ones. There are significant differences between the funds. For example, TCW Total Return invests heavily in mortgage-backed securities, while Metropolitan West Total Return is a diversified bond fund.
BETTING ON THE HOUSE
Right now, though, mortgage-related bonds are MetWest's biggest overweight and the part of the bond market the managers get most excited about. The team divides mortgages in two categories: agency and non-agency. Agency bonds are those from government agency Ginnie Mae, and government-sponsored entities Fannie Mae and Freddie Mac. About 30% of the fund is invested in these issues.
Non-agency paper is issued from the likes of GMAC and Bank of America, which service residential mortgages. It is this segment that Rivelle and his co-managers are especially keen on. About 18% of its assets are invested there.
The headlines are full of stories that point out the problems that mortgage-origination firms face. Last fall, several states tried to halt foreclosures while they investigated allegedly shoddy origination practices. The companies may be forced to buy back some of the loans they packed into mortgage-backed securities because of misrepresentations.
MetWest is undeterred by such legal messes. The managers argue that a worsening housing market is already reflected in the prices of the bonds. "We think it's an attractive asset class," says Mitch Flack, who co-heads the mortgage desk at TCW. "Home prices can continue to fall for years." When MetWest and TCW funds invest in non-agency mortgage-backed securities, the managers prefer senior securities, which are the last to take losses in case of defaults.
Rivelle and Flack believe that the low prices at which they buy these bonds-most were bought well below par-protects them; a large swath of mortgages in the pools could default without jeopardizing double-digit yields. Non-agency issues were among the best-performing segments of the bond market in 2010.
TREASURIES A NO-GO
The weak housing market is but one manifestation of the gloomy overall economy. The asset bubble that resulted from years of real estate speculation and easy credit will take years to deflate, he says. And that could prove to be painful.
Rivelle sees the Fed's decision to buy $600 billion worth of U.S. Treasuries on the open market, known as quantitative easing, as a reasonable action. But he points out that it is inflationary. Treasury yields are likely to rise to compensate investors for higher inflation.
Since November when the Fed action was announced, the yield on the 10-year Treasury note rose almost a full percentage point. Prices have fallen due to the inverse relationship between bond yields and prices. But Rivelle believes that the government will need to undertake more interventions in coming years to right the economy, causing yields to rise even more. As a result of this forecast, the team is steering clear of Treasuries.
Even at the higher interest rates, Rivelle believes that Treasury prices are overvalued. "When your fiscal authorities are degrading the balance sheet of the entity that guarantees them, and your central bank is saying that inflation is too low, that's not an environment that bodes well for Treasuries," Rivelle says.
Yet the timing of an interest rate move is unclear. So Rivelle and his co-managers have trimmed their duration, a measure of interest rate sensitivity, to five years, half a year short of their benchmark, Barclays Capital Aggregate Bond Total Return index.
CORPORATE CULTURE
Corporate bonds round out the holdings in MetWest Total Return. A banner year for these bonds in 2009 followed the credit crunch of 2008. But much of those opportunities have evaporated, Rivelle says. He is cautious. Slow economic growth can hamper firms' abilities to expand and their capacity to pay back debt. However, there are a few areas that are undervalued, he believes.
One is institutional money-center banks, like Citicorp and JPMorgan. MetWest has been investing in bonds of money center banks for several years, believing that they would outperform in a recovery. About 15% of the fund's assets are invested in these and other financial services bonds. Rivelle expects his picks in the sector to yield 6% to 8%.
Another area is enhanced equipment trust certificates, which are used to finance aircraft purchases for airlines. They are secured by pools of commercial planes and are separate legal entities from the airlines that purchase and use the planes. These bonds have yields between 6% and 10%, Rivelle says.
Finally, MetWest also likes taxable municipal bonds through the Build America Bond program used to finance infrastructure projects. Ordinarily, Met-West doesn't dabble in munis, but the Build America bonds are different. The federal government pays 35% of the coupon payments on the bonds (that amount will decline in coming years), giving bondholders a measure of protection against a municipal default. And the yields are too enticing to pass up.
"We can lend the state of California money at a 7.5% yield for 20 years," Rivelle explains. "True, California doesn't have the best financials, but 7.5% is a huge compensation." It's all a matter of balancing the risk with reward.
Ilana Polyak is a regular contributor to Financial Planning.
Tad Rivelle
Metropolitan West Total Return Bond
Age: 49
Credentials:
BS in physics, Yale University; MS in applied mathematics, University of Southern California; MBA, University of California, Los Angeles
Experience: Chief investment officer for fixed income, TCW Group (2010-present); portfolio manager, Metropolitan West Total Return Bond (1997-present); chief investment officer, Metropolitan West Capital Management (1996-2010); co- director of fixed income, Hotchkis and Wiley (1992-1996); portfolio manager, Pimco (1990-1992)
Ticker: MWTRX
Fund inception: March 1997
Style: Intermediate-term bond
AUM: $11.8 billion
Three-year performance as of Jan. 5, 2011: 8.4%
Five-year performance as of Jan. 5, 2011: 8%
Expense ratio: 0.65%
Front load: None
Minimum investment:
$5,000
Alpha:
2.97% vs. Barclays Capital Aggregate Bond Total Return index
