Western Asset Management Co.’s main fund is rebounding after trailing rivals in 2007 and 2008, beating similar strategies from BlackRock Inc. (BLK) and Pacific Investment Management Co. for the third straight year. The bond manager’s next challenge is to reverse withdrawals.
Western Asset, a unit of Legg Mason Inc. (LM), is earning praise from one hard-to-please critic: Nelson Peltz. The activist investor, Legg Mason’s largest shareholder and a member of the company’s board since October 2009, said the performance will eventually translate into client deposits, after 15 straight quarters of withdrawals at the Baltimore-based parent.
“Western will lead the way,” Peltz, founder and chief executive officer of New York-based Trian Fund Management LP, said last week in a telephone interview. “Western’s performance has been unbelievable. We did not think they would turn their three-year numbers around as quickly as they did.”
Western Asset, whose $333.5 billion in fixed-income assets make it the largest Legg Mason unit, has been responsible for most of the firm’s $197 billion in bond withdrawals since 2007 as bets on mortgage securities backfired during the credit crisis. Legg Mason is likely to report redemptions at the Pasadena, California-based unit when it reports results for the quarter ended Sept. 30 tomorrow, according to Daniel Fannon, an analyst at Jefferies & Co., and Jeffrey Hopson, who covers it for Stifel, Nicolaus & Co.
15% Annual Gains
Led by Chief Executive Officer James Hirschmann, Western Asset added risk-management tools and professionals starting in 2008 in an effort to break out of its slump. Including money- market funds, the division held $447.1 billion, or 67 percent of Legg Mason’s assets, as of June 30.
The $8.7 billion Western Asset Core Plus Bond Portfolio (WACPX), the mutual-fund version of the firm’s biggest strategy, advanced an annual average of 15 percent in the three years ended Oct. 24, beating 99 percent of competing fixed-income funds, according to data compiled by Bloomberg. Bill Gross’s $242 billion Pimco Total Return Fund (PTTRX) averaged 10 percent and the BlackRock Total Return Fund returned 9.6 percent a year.
Western Asset drew $100 million in net deposits in the three months ended June 30, ending a streak of withdrawals from the unit that began in December 2007. The new business highlighted “the momentum being built at Western,” Chief Financial Officer Peter Nachtwey said at a Sept. 13 industry conference.
Legg Mason CEO Mark Fetting has said improving fund performance at all affiliates is a priority after returning the firm to profitability from a $2 billion loss in fiscal 2009. In addition to Western, Legg Mason owns the Permal Group hedge fund unit, small-cap stock manager Royce & Associates and Bill Miller’s Legg Mason Capital Management division.
Legg Mason Stock
Legg Mason’s shares have lost 28 percent this year, compared with the 24 percent decline in Standard & Poor’s index of custody banks and asset managers. The stock is down 81 percent from an all-time high of $136.40 in February 2006.
The Legg Mason investment in mid-2009 by Peltz, who is known for pushing for companies to increase their value by cutting costs or merging, spurred speculation that he would try to break up the money manager and spin out Western Asset. Fetting said in a November 2009 conference call with investors that those rumors were false and that Trian has “no interest in that at all.”
“We like the way the arrows are pointing at Legg Mason,” Peltz said. “Management has embarked on a strategy we agree with. We believe it is a just a matter of time before the stock price reflects the merits of the execution of this strategy.”
Peltz, who helped spark Cadbury Plc’s 2008 spinoff of Dr. Pepper Snapple Group Inc. and pushed Wendy’s Co. to combine with the Arby’s sandwich chain the same year, declined to comment on his plans. Wendy’s earlier this year sold Arby’s to Roark Capital Group, undoing the tie-up.
On Oct. 16, Peltz admonished the board of State Street Corp. and urged it to adopt a plan to raise profit that included a possible sale of the custody bank’s money-management unit. Trian, which owns about 3.3 percent of State Street’s shares, wrote in an accompanying report that the asset-management unit is “meaningfully undervalued” as part of the custody bank and that the unit could become an acquisition candidate like Barclays Global Investors, which was bought by BlackRock in December 2009.
Peltz agreed to keep his Legg Mason stake under 10 percent as part of a “standstill agreement” that could end next year. The accord prohibits him from forming partnerships or syndicates to amass more voting interests or to force a breakup of the company. Trian, co-founded by Peter May and Ed Garden, reached a 9.98 percent stake as of Aug. 4, according to a regulatory filing.
$74 Million Surprise
Since Peltz became a Legg Mason director, the firm has bought back shares, cut jobs and moved certain technology functions to its investment affiliates as part of a goal to save $130 million to $150 million per year.
Fetting said in May that costs tied to Western Asset will rise by $74 million this year, delaying his goal of lifting profitability. Peltz and another director, KKR & Co.’s Scott Nuttall, were dissatisfied with the disclosure, two people with knowledge of the matter said at the time.
Western Asset, founded four decades ago by United California Bank, was acquired by Legg Mason in 1986, when it had $4 billion in assets, one office and 30 employees. Over the years, it became known for eschewing Treasuries and government debt while buying corporate and riskier bonds. Hirschmann, who joined in 1989, was named as head of the unit in 1999.
This year’s turmoil in global markets has prompted institutional investors to turn away from corporate debt, Hopson said in an interview.
“If anything, in August and September, people were moving to government bonds, which won’t necessarily benefit Western,” said Hopson at Stifel Nicolaus.
Western Asset may have had $10 billion in redemptions in the last quarter, he said. Fannon, a San Francisco-based analyst at Jefferies, predicted withdrawals of $3 billion to $4 billion in an Oct. 12 note to clients.
Even before credit market troubles reached crisis proportions in September 2008 with the failure of Lehman Brothers Holdings Inc., Western Asset had been trailing its peers for more than a year as investors fled to safer bonds. After funds including Core Plus lagged behind rivals in 2007, Western Asset hired a unit of Boston Consulting Group in mid-2008 to assess the firm’s investment processes.
The moves came too late to help the asset manager that year as positions in non-agency mortgage bonds and debt issued by financial companies were crushed after Lehman’s bankruptcy. The Western Asset Core Plus fund lost 9.8 percent in 2008, faring worse than 80 percent of its peers, Bloomberg data show.
“By the fall of 2008, there was no way you could change your positions,” Stephen Walsh, chief investment officer of Western Asset, said in a telephone interview. “Recognizing the poor job we had done as portfolio managers was the hardest.”
The credit crisis also brought another set of problems. Money-market funds that Legg Mason had inherited through its December 2005 acquisition of Citigroup Inc.’s investment unit had put as much as $10 billion into structured investment vehicles that plunged as investors shunned mortgage-linked debt in 2008. Legg Mason propped up the money funds using its own capital, causing five straight quarters of losses that ended mid-2009.
‘Play the Tapes’
The poor performance of bond funds in 2007 and 2008 triggered a reexamination at Western Asset that led to a change in the way it approaches risk, Hirschmann said.
The firm added quantitative tools focusing on returns to analyze investment processes and hired specialists trained in risk management, including Kenneth Winston as chief risk officer. It added investment staff with expertise in credit and non-U.S. fixed income, and vowed to be more vigilant in dialing down risk at the first signs of market trouble.
“We said let’s play the game tapes and see what we missed,” Hirschmann said in a phone interview. “We had to go through a significant self-assessment process.”
As Europe’s sovereign debt crisis started unfolding earlier this year, Western Asset put its new investment process to the test. The firm cut its investments in high-yield bonds by one- third in February and March, increased government debt and brought down investment-grade corporate bonds in line with benchmarks, he said.
Tempering risk helped Western Asset beat rivals this year. The Western Asset Core Plus fund rose 5.1 percent in 2011 through Oct. 24, compared with the 1.7 percent return for the Pimco fund and 3.1 percent for the BlackRock fund. As the sovereign crisis intensified in the three months ended Sept. 30, the Western Asset fund rose 1.6 percent while Gross’s Total Return fund fell 1.1 percent.
“We’re back on the offense,” Hirschmann said.
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