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Bond Managers Handling the Subprime Mess with Finesse

These fixed-income chiefs have exercised prudence and may profit from a recovery.

Paul Herbert, 08/21/2007

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition. Fund Analyst Picks are available on Premium Morningstar.com.

In the process of gathering information about the state of affairs for subprime asset-backed securities in recent weeks, we have spent a fair amount of time interviewing fund managers with positions in these bonds. We were able to learn more about a few managers who had developed an understanding of the risks involved early on.

(As a reminder, asset-backed securities are bonds backed by groups of financial assets, such as certain kinds of home loans. Their creditworthiness usually depends on the performance of these underlying assets.)

Below are managers who have navigated these conditions well--but it's not a complete list. There are plenty of other good managers--the big firms who run Fund Analyst Picks include managers at FPA, T. Rowe Price, Vanguard, to name just a few--who are doing well in this tough environment. But it's a good bet that the managers listed below will be in a better position to pick up quality securities on the cheap when they have determined that the worst is over or nearly over.

Metropolitan West
The team at Metropolitan West Asset Management, which runs Analyst Pick Metropolitan West Total Return Bond MWTRX, has been cautious on the subprime situation since at least 2004. At that time, it started writing to its clients about the growing market dependent upon mortgage lenders relaxing their standards and borrowers who were stretching beyond their means. Met West also warned that there could be potential losses for bondholders when the housing market slowed and interest rates rose.

The team's caution helped it focus on the better originators and to stay away from a lot of the loans issued in 2006, when underwriting standards really began to weaken. The Met West team has also been paying very close attention to bonds' structures. Asset-backeds are split up into groups according to ratings, and one of the team's strategies has been to focus on the highest-rated classes (or tranches) of subprime ABS, for two reasons. First, as borrowers repay their loans, the tier rated AAA gets paid first. Second, when borrowers default, losses hit the unrated and lowest-rated (usually referred to as "subordinated") portions before those above them, and are unlikely in many cases to affect the portion of the deal rated AAA at all. Met West has also held lower-rated classes issued in 2004 and 2005, after determining that their prices don't reflect the fact that there is ample subordination left below, cushioning them from losses. These moves have helped Total Return to sail into the intermediate-bond group's best 5% so far in 2007.

Portfolio manager Bryan Whalen, who heads up Met West's asset-backed and mortgage-backed securities group, said last month that he viewed the recent weakness in subprime ABS as a buying opportunity, but that he wasn't "backing up the truck" because of pricing difficulties.PAGEBREAK

The housing market has been at the center of PIMCO's economic outlook in recent years, so it's no surprise that the firm has spent a lot of time analyzing prospects of the subprime ABS market and the various ways to capitalize on its volatility. Scott Simon, head of the firm's mortgage-backed and ABS teams and portfolio manager of PIMCO Mortgage Backed Securities PTRIX, started calling in March 2005 for a top in home prices. His call may have been early for a while, but in 2007 he, and PIMCO for that matter, have appeared to be right.

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