TCW Group Inc.’s wager on risky mortgage bonds, which last year caused the money manager to trail 87 percent of competitors, is paying off now as investors in the securities shrug off Europe’s debt crisis amid signs U.S. housing is stabilizing.
TCW’s $5.6 billion Total Return Bond Fund gained 5.2 percent through May 18, beating more than 97 percent of rivals, Morningstar Inc. data show. The fund has 37 percent of its holdings in home-loan debt that isn’t backed by the U.S. government, including 11 percent in subprime-mortgage bonds, the type of debt that contributed to the 2008 financial crisis.
The focus on less creditworthy borrowers this year helped TCW outperform rivals including Pacific Investment Management Co. and DoubleLine Capital LP. The $1.1 trillion market for so-called non-agency mortgage debt rebounded as housing starts climbed, foreclosures slowed and home-price declines eased, signaling a six-year property slump is bottoming. While TCW isn’t banking on a housing recovery, investors are too pessimistic on mortgage defaults and recoveries, said Bryan Whalen, its co-head of mortgage bonds.
“You don’t have to be bullish on housing to be bullish on non-agency mortgages,” said Whalen, who’s based in Los Angeles and manages the fund with TCW’s Tad Rivelle, chief investment officer for fixed income. “Of all the credit assets out there, this one still has the worst outlook embedded in its pricing, which gives us a lot of cushion.”
Reversal From 2011
Returns on subprime mortgage bonds issued in 2005 through 2007, the years with the worst loans, have averaged 11.2 percent this year through May 18, compared with 1.4 percent for government backed home-loan securities, according to Barclays Plc index data.
That’s a reversal from the final 10 months of 2011 when subprime debt lost 8.4 percent as investors fled risky assets after Standard & Poor’s in August stripped the U.S. of its top credit grade and Europe’s fiscal crisis intensified. Agency securities gained 5.9 percent during the period.
Non-agency debt, which encompasses subprime, Alt-A, a type of home loan that typically didn’t require as much documentation such as proof of income, and prime mortgages, climbed about 8 percent this year, Whalen estimated.
Gains have narrowed as Spanish 10-year bond yields exceeded 6.2 percent last week, approaching levels that prompted bailouts for Greece, Ireland and Portugal. The rate fell 19 basis points today to 6.09 percent.
The potential for increased regulatory scrutiny after JPMorgan Chase & Co. said this month it lost $2 billion by trading in indexes tied to credit-default swaps has also “weighed on investors,” Bank of America Merrill Lynch strategists led by Chris Flanagan wrote in a May 18 report.
“The non-agency market has until this week held in despite the sell-off in the broader markets,” the strategists wrote. “However, we believe this relative strong performance instead makes the sector more vulnerable to selling as investors lock in gains and move up in quality.”
While TCW has opted to add subprime mortgages, the $25 billion DoubleLine Total Return Bond Fund has focused its non-agency mortgage-backed debt purchases in prime debt. Run by former TCW fixed-income head Jeffrey Gundlach, the fund had 33 percent of its money in non-agency mortgages as of April 30, with 50 percent of that in prime, 42 percent in Alt-A and 7.3 percent in subprime, according to DoubleLine’s website.
‘Did the Opposite’
The fund has risen 4.1 percent this year, ahead of 90 percent of peers, after beating 98 percent of rivals in 2011. Pimco Total Return Fund, managed by Bill Gross, gained 4.78 percent through May 18, better than 96 percent of rivals, Morningstar data show.
“Most investors loaded up on credit last year and underweighted government bonds,” Gundlach said in a March interview with Bloomberg. “We did the opposite.”
Non-agency debt holdings in the TCW Total Return Bond Fund include 37 percent in Alt-A, 30 percent in subprime and 21 percent in prime mortgages, data from its website shows. The firm manages $131 billion.
Current prices for Alt-A debt imply that 50 percent of the mortgages will ultimately default and investors will recoup 35 percent of their money, Whalen said. TCW’s analysis of the market suggests the default rate will be closer to 40 percent and recovery rates more like 45 percent.
Non-agency can do well if the economy grows at a moderate 2 percent to 2.5 percent pace and the housing market doesn’t improve, said Whalen. The U.S. will expand 2.3 percent this year, compared with 1.7 percent in 2011, according to a Bloomberg News survey of economists.
“We don’t have rose-colored glasses when it comes to housing,” he said. Home prices could show “no material recovery” for a few years because at any sign of improvement, sellers will jump into the market and push prices back down, he said.
Economists including Bank of Tokyo-Mitsubishi UFJ’s Chris Rupkey, Bank of America Corp.’s Michelle Meyer and Mark Fleming of CoreLogic Inc. are predicting home prices are close to a trough after an S&P/Case-Shiller index of property values in 20 cities fell 3.5 percent in February, the smallest 12-month drop since February 2011. The index has declined 35 percent since peaking in 2006.
Sales of existing U.S. homes rose in April for the first time in three months, figures from the National Association of Realtors showed today in Washington. Purchases of previously owned houses, tabulated when a contract closes, increased 3.4 percent to a 4.62 million annual rate. The median forecast of economists surveyed by Bloomberg News called for a rise to a 4.61 million rate.
Gundlach has said he avoids most subprime, in part, because the mortgages are poor credits and are less likely to be refinanced. The prime and Alt-A mortgages in the portfolio, purchased at deep discounts to par, may produce a windfall if there is a wave of refinancing, he said.
The “bounce back phase in junky assets,” including mortgages, may be over, he said.
The U.S. housing market will “bumble along,” and bond markets will mark time, he said. In speeches and conference calls, Gundlach has emphasized the U.S. debt burden and questioned the strength of the recovery. “Surprises are likely to be on the negative side,” he said in an April interview with Bloomberg.
That attitude shapes his investment decisions. “We are staying on the safer side when it comes to credit,” he said. “If the market explodes we will be more protected.”
Gundlach created the flagship DoubleLine Total Return Bond Fund in April 2010, four months after he was ousted as chief investment officer at TCW. It attracted $6.4 billion in investor deposits in the first quarter of this year, more than any other U.S. mutual fund. The Los Angeles-based firm has $34 billion of assets.
Since the fund was created it’s returned 33 percent through May 18, compared with 19 percent for TCW Total Return.
Rivelle, previously chief investment officer for Metropolitan West Asset Management, took over Gundlach’s old fund in December 2009 when TCW bought the money manager.
While TCW’s Whalen said non-agency mortgage debt could return as much as 15 percent for 2012 if Europe’s fiscal challenges are addressed and global stock markets move higher, gains will be more modest if the economy weakens or the U.S. fails to deal with its budget problems.
“Non-agency can’t get too far ahead of the rest of the credit market,” he said.
One plus for the securities is that the supply of bonds is shrinking as loans are refinanced, go into default or are paid off.
“The mortgages are harder to find and that supports prices,” said Paul Jablansky, who heads structured products at Pasadena, California-based Western Asset Management Co., the bond unit of Legg Mason Inc. The non-agency market has shrunk to less than $1.1 trillion, from the 2007 peak of $2.3 trillion, according to data compiled by the Federal Reserve.