These fixed-income chiefs have exercised prudence and may profit from a recovery.
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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.
The team at Metropolitan West Asset Management, which runs Analyst Pick Metropolitan West Total Return Bond
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.
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
It also isn't unexpected given PIMCO's comfort with derivatives that the firm has used derivatives contracts rather than bonds to express its bearish view on the subprime market. The Mortgage Backed Securities fund has been long credit-default swaps, which are instruments structured to pay off for their holders when negative events such as defaults take place. Simon expects that taking that position added about 20 to 30 basis points (or 0.20% to 0.30%) of performance for the fund, which has been torching its intermediate-term government peers in 2007.
Simon, whose input on mortgages informs the work of diversified portfolio managers at PIMCO, including Bill Gross at Total Return
Though some of Western Asset Management's funds, including Analyst Pick Core
Western hadn't been buying into lower-rated securities at the time we talked to them, but Mass said he has been a buyer of attractively valued higher-rated fare with characteristics similar to those mentioned above.
Paul Herbert, CFA, is a senior analyst with Morningstar.