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Opportunities in High Yield Bonds Dimming

Eric Jacobson

Eric Jacobson: Talk to us a little bit about what was happening with the portfolio. What kinds of things you and team were thinking about, coming into, say, the latter end of '06 into '07 and the kind of decisions you were making. You kind of touched on this in more specifics here. But give us a broader feel, what was the thinking that went into the portfolio positioning at that point?

Jamie Farnham: It's a good question. As a value-driven manager, we acknowledge that we can't call the top or the bottom, we just have to look at it through a long-term lens. So in late '06, early '07, and even on into the early part of '08, when you looked at the high yield market, and the average spread in the high yield market was in the low 200 basis points at one point in 2007. From a historical standpoint, it was unprecedented. And given the risks inherent in the LBO wave, it just didn't make sense. So we positioned ourselves quite conservatively in that time frame and just waited. Now admittedly, it was a difficult time period for us. There was a bit of lag in our portfolio as we waited for the credit cycle to unfold.

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However, as a the credit cycle is a continuous phenomenon, that did start to percolate up as 2007 started its season, and particular into 2008. Now what's particularly interesting when we go into 2008, in mid-2008, when the high yield spreads got to 1,000 basis points, using a historical timeframe and measurement, that's the normal buy signal.

However, our approach at Metropolitan West, and now TCW, is using a team-based approach and incorporating the views of the corporate side with the structured products. And that continuous discussion of opportunities within the marketplace saw that even with 1,000 basis points over within the high yield market, it was very optimistic--relative to the assumptions that were being built into the structured finance market. It was precisely at that time that we got more defensive in the middle of 2008.

Now we weren't able to predict that there was going to be a Lehman default or bankruptcy. However, that did cause an unprecedented wave of de-leveraging in September of 2008. That caused high yield spreads to double to 2,000 basis points.

Now using our long-term discipline, we began to increase risk at approximately that time frame. We didn't call the bottom, nor do we aim to. It's more taking a dollar cost averaging approach. At that time, the assumptions being built into the leveraged finance markets or the credit markets were more in line to the structured finance counterparts.

So it's acknowledging that investors aren't just looking at one market in isolation, but looking at the total return opportunities, both in 2007 and in 2008, and really, it didn't make sense for distressed money to go in and invest in high yield when there was more compelling opportunities within the structured finance market at that point in time.

Jacobson: So take us, then, from that sort of turning point, the decision making becoming more aggressive, take us into 2009, and tell us how that decision making evolved into 2009, and where it's taking us up to now.

Farnham: It's been a remarkable 2009, in that the high yield market turned. The equity market turned much later. The high yield market turned at approximately December 15th of 2008. And so you had the high yield market started, give or take, 1,900 basis points over treasuries in early January of 2009. As we sit here today, it's in the mid-600s. So obviously, the relative value of the market has evolved considerably.

We periodically look at--we look at the credits on a bottoms-up basis continually every day. Reevaluate the portfolio at least once a month to look at, "Are there any economic trends versus the relative values out there?" So we have evolved from a very opportunistic positioning in early 2009. That evolved from November to January, and we kept that positioning through early to mid-2009.

As we have gone through from the summer of 2009 to now, we've gradually dollar cost averaged and reduced the opportunistic positioning of the fund, and now are market weight to slightly underweight the market on a high yield basis at this point in time, given that, it's been quite a robust run.

Now the undertones of that positioning really comes down to where the fundamental strength of the economy is. And we still think it's going to b--the prospects of the economy are unclear and probably tepid at best. There's still significant over-capacity in both the industrial side and capacity utilization, as well as the labor side. The consumer is not going to have an easy time bouncing back and spending to the degree that they did over the prior decade.

And it's the absence--the excess capacity is going to cause meager cap-ex spending. This should affect the lower tier of the high yield market quite considerably. And for those reasons pulled together, is we're cautious on the lower tier as we sit here today--the lowest tier of the high yield market, in a significant fashion.

But we still remain relatively constructive for the higher quality and the middle quality of the high yield market, and believe that it's a good risk-adjusted return in this market environment, within those segments of the high yield market.

Jacobson: Great. Jamie, thanks so much for you time talking about the high yield fund. We appreciate it.

Farnham: Thank you, Eric.