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By Eric Jacobson | 04-11-2011 12:06 PM

How TCW/Met West Is Positioned for a Rising Rate Environment

Corporates and non-agency mortgages will probably be fairly resistant to rate rises, at least in their initial phases, says TCW/Met West fixed-income CIO Tad Rivelle.

Eric Jacobson: So, Tad let's switch gears for a second and look at what investors are concerned about today, and I think it's no secret that most people are very, very worried about the possibility that you laid out about the Fed raising short-term rates a great deal and the market reacting the way one expects them to. What do you think, individual investors should be thinking about the effect that such an outcome can have on their portfolios? With the premise being that I think a lot of people are frankly extremely worried that it's going to destroy their fixed-income portfolios?

Tad Rivelle: Right, as fixed income investors recognize the key determinant as it relates to the pricing of bonds is interest rates and the direction thereof. Since 2008, or maybe I should March of 2009 that was really the low point, it has largely been a one way trip for most of the sectors of the fixed-income market. Beginning in March of 2009, we have seen, dramatic rallies of course in equities, but they have been mirrored in the high-yield bond market which turned in more than 50% return over the course of 2009. Enduring and very significant gains in non-agency, non-conforming mortgage loans. Good gains in corporate paper. Good gains in Treasury securities.

So, first of all recognize that there are variety of different asset classes in fixed income. They don't all quite move together, and so consequently, they won't all quite move together on the way up as well, the way up in terms of interest rates. And because in the sense there are many interest rates, if I could put it that way, though there are correlations between the two of them, to a great degree what will happen to an individual bond portfolio will be a function of what kind of bonds you own.

It is our view, our expectation is that to the extent to which an investor is in a bond fund or owns bonds that are for instance largely Treasury-related and longer in terms of maturity, that's probably an area that may see more in the way of price erosion than for instance a portfolio that is more focused on let's say the corporate asset class or let's say non-agency mortgages, which we actually think will probably be fairly resistant to rate rises at least in their initial phases.

Jacobson: So you mention corporates and non-agency mortgages, those are two significant parts of your core or core plus strategies, the kinds of things that make it in, for example, to Metropolitan West Total Return. Can you give us a thumbnail of what some of the other sectors are and sort of the sizing of those bets, and what you're doing on interest rates in that portfolio?

Rivelle: Sure. Well, as you mentioned, the non-agency mortgages have been a big thrust of the investment strategies, and across many of our bond funds in recent years, and that largely relates to a belief on our part that there is a distortion, so to speak, in the pricing of non-agency mortgages. That in turn is related to the fact that non-agency mortgages in effect represent--if I could put it this way--a legacy pool of loans that were originated back in 2005 and 2006.

They represent claims on residential properties, many of which are under water, and in a sense, because we have been, collectively as a society for a lot of good reasons, been slow to in a sense work through this overhang of underwater properties: We've been reluctant to foreclose. Banks have had perhaps a certain degree of regulatory restraint. In judicial states, courts are backed up with respect to the foreclosure proceedings. Be that as it may, whatever the reasons are, the surplus of underwater properties leads to a surplus of, in effect, underwater non-agency mortgage loans.

Non-agency mortgage loans did about 20%-plus on average in the course of 2010, and they're likely to do actually probably pretty well as we look into 2011. So they've been a big thrust, as you've indicated.

Corporate securities have also been an important part of the evolution of our strategies. The part of the corporate bond market that we have found most favor with in recent years, and in the current period, actually represent the bonds in connection with systemically critical financial institutions; that's I guess a fancy way of saying, large banks, money center banks, Wall Street firms, and so forth. Bonds of a number of different companies that the compliance folk would probably shake a stick at if I mentioned them, but I think that many of the viewers would recognize.

We also like some of the higher tiers, the higher-quality levels of the high-yield bond market, that's the BB and the B variety. We're of the view that a number of the CCCs--I think CCCs are maybe about 15% to 20% of the entire high-yield market currently--but many of those CCCs were originated during the boom years, and there's been a case of extend and pretend with respect to some of those loans that they will ultimately see a come-uppance.

Agency mortgages are also of interest. The interesting aspect of agency mortgages is that from our point of view, the Fannie Mae and Freddie Mac guaranty is basically as good as the U.S. Treasury guaranty, given the conservatorship that they were placed into in 2008, and that furthermore the ability of the homeowners that represent the other side of the coin, so to speak, with respect to the bond holders' investment in these agency mortgage loans, has very limited options with respect to prepayments.

The prepayment option which is such a big plus for the homeowner is correspondingly a minus for the investor in agency mortgages. But because of the inability to robustly refinance these agency mortgages, they represent in effect the good deal for the investor, and they represent a very significant portion of our fixed-income portfolios.

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