Mortgage-backed securities are the most complex and misunderstood of the fixed-income instruments, says Jeffrey Gundlach, one of the two co-managers of the $477 million TCW Galileo Total Return Bond Fund (TGLMX). But where others shy away, Gundlach sees the market's rampant inefficiency leading to tremendous investing opportunities. His fund, a Standard & Poor's/BusinessWeek best fund manager selection for the fourth consecutive year, earned an average total return of 6.4% a year over the 2001-05 period, better than most peers and with less risk, according to S&P.
Gundlach, 46, along with co-manager Philip Barach, 53, starts with a proprietary mathematical model of the behavior of mortgages that often spots bargains where others don't. Last year, for example, investors were avoiding principal-only securities, known as POs. The securities receive only the principal payments, not interest, from an underlying pool of home loans.
Properly valuing POs requires figuring out just how fast homeowners are going to repay the loans. The securities had been trading at huge discounts as interest rates rose, on the premise that homeowners would hold onto their lower-rate mortgages rather than refinance or move. Gundlach thought otherwise, and loaded up on POs with loans made in 2002 and 2003. He was rewarded with a 14% average return on his investments when as the feared slowdown in prepayments didn't materialize.
WHAT HOUSING BUBBLE? Gundlach is still bullish on mortgage-backed securities, especially those same loans originated in the 2002-03 period. He thinks he will be able to make more than twice as much from them as from Treasury bonds.
What about the housing bubble? Gundlach doesn't see it. But even if he's wrong, he says he's doubly protected. The homes bought three and four years ago have already appreciated more than 30%, giving homeowners a pretty big cushion even if prices do fall. And all the mortgage obligations in the TCW fund carry triple-A bond ratings, because the loans are backed by Fannie Mae (FNM) and Freddie Mac (FRE).
One thing you don't find in the TCW fund lately is corporate bonds. Many total-return funds shift their investments around between the different fixed-income classes based on what looks cheapest. Gundlach concentrates on what he knows best. "The traditional method of switching around sounds good but we're more consistently successful," he says. His investors would certainly agree.