The Secret to a Top-Performing Bond Fund May Be in Europe

Gary Herbert manages a bond fund that’s beating 97 percent of his peers with 11 percent gains this year. The reason: mortgage debt in Europe.

Herbert, who manages the Legg Mason BW Alternative Credit Fund, is joining Blackstone Group LP and Lone Star Funds in buying mortgages in European nations, especially those that are struggling the most, such as Spain, Portugal and Greece.

U.S.-based fund managers have started to gravitate toward Europe’s higher-yielding debt and stepped back from speculative-grade bonds at home. While this may seem somewhat counterintuitive given the U.S. economy looks more robust than Europe’s, it’s a bet that the European Central Bank will accelerate its stimulus and boost demand for less-creditworthy debt. That’s poised to happen at the same time that the Federal Reserve starts raising interest rates in the U.S.

“We’re trying to exploit pessimism in Europe,” said Herbert, who’s worked in the bond market for more than two decades and is a fixed-income asset manager at Brandywine Global Investment Management LLC. “We saw an opportunity like what we saw in the U.S. after the credit crisis.”

The Legg Mason fund started buying European residential mortgage-backed securities in January from banks and insurance companies looking to reduce their holdings of riskier assets, Herbert said. The $654.3 million fund has outperformed 95 percent of its peers during the past three years, according to data compiled by Bloomberg.

Fund Performance

It’s also the top performing in the past year among non-traditional bond funds tracked by Morningstar Inc. The category has become increasingly popular during the past two years as investors seek flexible strategies that rely more on managers’ debt-picking acumen, instead of funds that aim to track the market as the Fed prepares to raise borrowing costs.

High-risk European debt has piqued the interest of other U.S. investors, too. Blackstone bought about 6.4 billion euros ($7.9 billion) of mortgages from CatalunyaCaixa, the firm said in July. Cerberus Capital Management LP, Goldman Sachs Group Inc., Lone Star Funds and Oaktree Capital Group LLC were also among investors that took part in the bidding for that auction, people familiar with the sale said at the time.

Commerzbank AG marketed more than 4 billion euros of loans linked to Spanish real property earlier this year as it wound down its real-estate financing arm.

Riskier bonds in Europe are generally outperforming similar notes in the U.S. For example, European high-yield bonds have gained 5.9 percent this year, while similarly rated dollar-denominated debt has returned 3.3 percent, Bank of America Merrill Lynch index data show.

There’s a sense among fund managers that there are few bargains left in the U.S. debt market. It may be time to go overseas.

(A previous version of this story corrected the name of Lone Star Funds in the second paragraph.)

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