Brandywine Joins Funds Seeking Yield From Spain to IHOP

Photographer: David Ramos/Bloomberg

Spain's economy expanded last quarter at its quickest pace since 2007, beating Germany for the first time in five years. Close

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Photographer: David Ramos/Bloomberg

Spain's economy expanded last quarter at its quickest pace since 2007, beating Germany for the first time in five years.

Tracy Chen, a portfolio manager at Brandywine Global Investment Management LLC, kept her eye on Spanish mortgages for three years. Once labor productivity hit her target in January as Spain’s economy began to accelerate, Chen seized her chance.

Chen has kept buying through this month, swapping some of her Legg Mason BW Alternative Credit Fund’s (LMAMX) holdings of non-agency U.S. residential mortgages for mortgage-backed securities in Spain, Greece and Portugal as those markets stabilize. The bets helped the fund win the No. 2 spot for performance in 2014 among non-traditional bond funds, according to Morningstar Inc.

“The European trade is still in the third or fourth inning while the U.S. non-agency trade is in the seventh or eighth,” said Chen, who’s managed the fund since its inception in August 2010. “There were so many more opportunities in 2010, but now non-agency prices are much higher and the market has become so much more efficient.”

Managers at Brandywine, Western Asset Management Co. and other funds are evaluating and shifting some of their holdings of U.S. mortgage-backed bonds to other asset-backed securities. The rally in mortgage bonds that aren’t insured by the government has slowed as the housing market has recovered from the 2008 crash. So everything from securities tied to pools of student loans to fees franchisees of restaurants like IHOP pay parent companies are luring investors as issuers push sales to the highest level in five years.

Subprime Auto

Returns are shrinking on the riskiest non-agency mortgage bonds, or subprime. Investors reaped gains of 41 percent in 2012 compared with 17 percent in 2013, according to Barclays Plc index data. This year through Aug. 14, the debt returned about 10 percent, the data show.

Buyers of mortgage-backed securities also face fewer opportunities. Deals tied to new non-agency loans were about $4 billion this year, according to data compiled by Bloomberg. Sales peaked at $1.2 trillion annually in 2005 and 2006.

Some money managers have been shedding their mortgages with government backing this year in anticipation of the end to the Federal Reserve’s bond buying program, which could cause prices to fall, said Matt Jozoff, an analyst at JPMorgan Chase & Co. Some of that money is going into Treasuries and asset-backed securities with higher yields, such as student loans and subprime auto debt, Jozoff said.

Spanish Mortgages

Brandywine’s Chen increased her fund’s exposure to Spanish mortgages and other European asset-backed securities to about 70 percent as of July 31. She said she likes certain Greek mortgages because borrowers are mostly public employees whose payments are deducted directly from their salaries.

Spain’s economy expanded last quarter at its quickest pace since 2007, beating Germany for the first time in five years. Greece’s economy contracted at its slowest pace in almost six years.

Prices of Europe’s debt should benefit if the European Central Bank starts buying asset-backed securities, Chen said.

“The underwriting standards in Europe are still more solid than they were in the U.S.,” said Chen, whose Philadelphia-based firm is a subsidiary of Legg Mason Inc. and oversees $58 billion in assets. “Most of the quality in Europe is what we would consider prime. So we can achieve higher returns with less risk.”

Chen’s $188 million fund returned 9 percent this year through July 31 and an annualized 21 percent since inception four years ago, Bloomberg data show. The fund’s 2014 returns earned it the second spot, behind the Cedar Ridge Unconstrained Credit Fund, among 86 non-traditional bonds funds tracked by research firm Morningstar.

Student Loans

Private student loans to borrowers with higher credit scores are attracting money from Western Asset. U.S. student loan debt totals more than $1 trillion.

By focusing on less risky loans, even if the economy slows down, fewer of those borrowers will default, said Anup Agarwal, head of mortgage and asset-backed securities at Pasadena, California-based Western Asset. The firm manages $469 billion in assets and is the biggest bond unit of Legg Mason.

While the firm still has significant investments in non-agency mortgages, there are better returns to be made in student and small business loans made by private lenders, Agarwal said.

“We keep looking for areas where the banks used to lend and aren’t really doing it anymore, so there are private lenders filling in,” Agarwal said. “That’s where the more attractive pricing is.”

Esoteric Securities

More traditional asset-backed securities like autos and credit cards offer low yields and aren’t worth investing in right now, said Brad Friedlander, co-founder of Angel Oak Capital Advisors LLC in Atlanta. He said he prefers a supplemental allocation to more esoteric securitizations whose return of principal aren’t correlated to the movements of other holdings in his $2.8 billion Multi-Strategy Income Fund. (ANGIX)

Friedlander reduced the agency mortgages in the fund to zero this year, increasing its cash holdings and diverting some of it to non-agency mortgages, commercial mortgage-backed securities and non-traditional asset-backed securities.

“The fund is designed to play relative value among all these spaces -- CLOs, CMBS, ABS, even agency MBS,” said Friedlander.

Angel Oak’s non-traditional asset-backed holdings include pools tied to payouts from large insurance companies to plaintiffs following court cases. Investors rarely suffer losses and yields are as high as 5 percent, Friedlander said. He said he also likes securitizations of the income streams from lease payments made by solar panel buyers, especially deals from SolarCity Corp., where billionaire Elon Musk serves as chairman.

IHOP Bonds

Some of the less traditional asset-backed securities markets lack liquidity. That’s why John Kerschner, global head of securitized products at Janus Capital Group Inc. (JNS), started focusing on more liquid whole business securitizations in the last couple of months.

Firms such as DineEquity Inc., whose brands include Applebee’s and IHOP, are offering securitized bonds this year that are tied to the fees franchisees pay to the parent company.

The deals make sense for iconic brands that are expanding, said Kerschner, who’s based in Denver and co-manages the Janus Multi-Sector Income Fund. Deal sizes have also been attractive, at about $1 billion, which means investors can buy a large block of bonds.

“If we’re getting new money, we’re looking for the best ideas -- whether it’s in esoteric ABS, CMBS or corporate credit,” Kerschner said.

To contact the reporter on this story: Alexis Leondis in Washington at aleondis@bloomberg.net

To contact the editors responsible for this story: Vincent Bielski at vbielski@bloomberg.net Kara Wetzel

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