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

Eric Jacobson

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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Jacobson: So in those portfolios, and in general in your core strategies, I understand you are a little bit short, your benchmarks in terms of duration, interest rate sensitivity, if you will. Can you frame that both in terms of the fact that you are little short and the relative magnitude there versus being either neutral or very short against the things that you've said already about your expectations for the future of the interest rate markets.

Rivelle: Right. Well, again as I'm sure many recognize, duration, which is a measure of interest rate risk, like yield is a forward looking estimate in effect. What duration is attempting to proxy or to measure is the likely amount of price sensitivity that a bond or a bond portfolio would experience under conditions of rising interest rates. So, there have to be a certain amount of assumptions made between how corporate bonds and agency mortgages, non-agency mortgages, taxable munis, which we have as well, would respond under a condition of higher rates.

To frame it, though, is that duration is measured in years. Each year of duration basically recognizes or attempts to measure this fact, which is that a 100 basis point rise in rates, or a 1% increase in rates for every year of duration should have approximately a 1% impact on the overall portfolio. So, if a mutual fund has a duration of let's say five years, and interest rates go up by 1%, by a 100 basis points, that 1% times a five years in duration should translate to a minus 5% with respect to the price movement of the bonds.

Now, recognize there is also yield coming off of a bond portfolio, and so to a large degree, the return profile of a bond portfolio will be impacted not just on the amount of rate rise, but also dependent upon how long it takes to get there and what kinds of bonds that that we have. But we are about six tenths of a year, not quite three quarters of a year is what I was going to say, about six tenths of a year short our benchmarks. We limit our duration shifts to have been plus or minus one year. So, we are fairly defensive based upon where we have been historically.

Jacobson: Just to make sure people understand, given the overall thinking that rates are headed up, what's the case against being as short as you possibly can right now?

Rivelle: Well, in part being excessively short may be suggestive of the position that the Fed is effectively in effect ready to pull the ripcord with respect to zero rates in the here and now. We don't think that's probable or likely, in fact though it is our belief that when we exit zero rates there will be a very significant rise in rates, we are not anticipating that to happen in 2011--that doesn't mean that it won't happen in 2011--but we don't consider that to be a likely possibility.

The approach that an investor can take is to consider low duration bond strategies. Low duration bond strategies, by definition, mean that the portfolios are typically comprised of shorter average maturity, although sometimes one also needs to understand whether those shorter average maturities are securities that actually mature in a couple of years or are primarily comprised of, let's say, floating-rate instruments that maybe mature in a long time but have a low level of interest rate sensitivity with them.

Basically, the primary reason for considering or sticking with a core bond strategy is the wider range of options. Having said that, there is certainly no reason necessarily why an investor ... whose primary concern is that of capital preservation, should probably be looking at bond funds or strategies that seek to reduce the amount of interest rate sensitivity through low duration or through some other type of active management.

Jacobson: Then one last question, what do you think the risks are, in terms of a rising rate scenario, to the Fed pulling back on its quantitative easing later this year, which is highly anticipated?

Rivelle: Right, in fact, I think for all intents and purposes we are already at the end of the quantitative easing program. If the Fed was going to do anything but continue it's program of securities buying, I think we would know about it by now. It ends in June, that's two months away from now. So I think that for all intents and purposes the Fed has accomplished what it wanted to. And what we believe they wanted to do was to help on the one hand reduce the market's fears about deflation. Six months ago, nine months ago, if we were having this conversation, we might be asking, what's the possibility of deflation versus the possibility of inflation. Notably, nobody is really asking that question anymore, which suggests that in effect, the Fed has succeeded in managing away those fears. But you can't manage away the fears of deflation without incrementally increasing the fears of the other side of the coin, the inflation.

Jacobson: So do you think however that the market is fully priced in the effects of that QE2 rolling off, or would you anticipate there is going to be some more volatility coming up this summer perhaps?

Rivelle: Well I don't think that the end of QE2 in of itself is likely to produce much in the way of any type of volatility. We've already seen, in a sense, kind of arguably a test front for the ultimate exit from QE2, because recognize that there are several elements of this: The Fed has accumulated more than $1 trillion worth of assets on its books, a lot of that has been in mortgages and agency mortgages. Some of it has been in Treasuries as well. The U.S. Treasury separate and apart from what the Fed has been doing, also accumulated a couple of years back a significant position in mortgages as well, and to a certain degree, they are around experimenting with the exit strategy with respect to those securities even as we speak.

Jacobson: Great, thank you very much for your time Tad we appreciate it.

Rivelle: Thanks so much.