Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Not every good bond-fund manager is swinging around hundreds of billions of dollars. Joining me to share some off-the-radar bond-fund picks is Eric Jacobson; he's a senior analyst for active strategies at Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: It's great to be with you, Christine.
Benz: Eric, let's set this up for our viewers and talk about why one would even consider a smaller bond fund when you've got these very large, proven quantities that you could invest in instead.
Jacobson: Well, the case is not quite as strong probably in those big, core areas. As you say, we have some big [bond funds] that have very good records, but some of it is personal taste. There are people who want to try and see whether they can do a little better than, say, Bill Gross at PIMCO Total Return because it's so big, and so forth. There are some advantages with size at that core-fund level, but where it really starts to matter is for other kinds of categories.
Benz: So, being small is an advantage in which types of categories, generally speaking? The less liquid categories?
Jacobson: Well, it's interesting because that's kind of a balancing act. You don't want to be too illiquid, obviously; but one thing that you can do with some of these smaller categories is you can buy bond deals or loan deals, for example, in the bank-loan space that are a little bit smaller in terms of the whole issuance. And the reason that that may be an advantage is that you can get a little bit more bang for your buck. You can hold a little bit more of it--a larger position than, say, maybe you would be able to build up in a really big fund, where you could be buying millions and millions of dollars in bonds and you're still only 20 basis points, or 0.20% of the whole fund or something.
Then, the other issue too, of course, is not unlike small caps on the stock side, for example, there are companies that are not well covered, especially if they are not public and they have debt outstanding. You can really uncover something potentially as a really strong manager with good research, and that can be really additive to the results of a good small fund.
Benz: Big funds can do that research too, but they may not be able to get that much bang for their buck by uncovering one of those smaller, off-the-radar-type holdings.
Jacobson: That's exactly right. Obviously, we use PIMCO Total Return as a big example all the time, but it is a key one to look at because if you just look at individual names, for example, if they wanted to do it all in cash bonds, there's a relatively limited set of corporate issuers--just as an example--that they could really build up much of a position in. Well, the good news is that you can use derivatives and so forth, but the single-name credit default swaps in the corporate bond market aren't as popular as they used to be; they're not all that liquid. PIMCO makes up for it with good macro calls and sector decisions and things like that most of the time. But it's a challenge for them to do that kind of thing, whereas a relatively small fund has a lot more choices and options and things like that.
Benz: You've brought a few different ideas for our viewers--things that are on our analyst coverage list--that we think deserve maybe a little more attention than they've gotten. There are two funds from Baird, and they operate in sort of core categories. So, there's not an inherent advantage to being small for these funds, but you think they're still good core picks.
Jacobson: Right--well, I want to be careful and say, in some cases, we're not necessarily out recommending these, but these are interesting, good funds to look at. The Baird funds, we've been covering that shop on and off for many, many years.
Benz: So, this is Baird Aggregate and Baird Core Plus in this case.
Jacobson: And in their case, a lot of it has historically had to do with [the fact that] they've got low fees, they've got good research, they're very cautious most the time. In some ways, [they're] kind of bland in the sense that there's not a huge, exciting story all the time to tell. But that's really what a lot of people want from their bond funds, and they've usually done a very good job of earning enough extra over the benchmark and over their expense ratio to make it worth taking a look at their funds.
Benz: Expenses: I want to touch on that because, with these core-type categories, expenses are very, very impactful in terms of performance. How do these Baird funds stack up?
Jacobson: Really well. The institutional shares are very affordable--I think about 30 basis points if you can access them through a platform or what have you. I believe the investor shares are in the mid-50s--something like 55 basis points.
Benz: Eric, your next idea is a fund where being small might actually be an advantage. It operates in the non-agency mortgage-backed space. Let's talk about what this fund is and why you think is it's maybe worth a little more investigation and why, in fact, our analysts are probably going to be checking up on this fund in the future.
Jacobson: Just a quick refresher: The non-agency mortgage sector was a big part of the market that blew up in 2007-08. These were mortgages not backed by Fannie Mae, Freddie Mac, or Ginnie Mae. They got beaten down very, very badly. Most investors shied away from them because they didn't want to touch the stuff, and many of them didn't have the expertise necessary--and they knew that--to really dig into these things and pick up the best of the worst, if you will. They've been a great source of returns for the last several years. Now, the category has shrunk a lot--the universe of loans, bonds available, mortgage-backed securities--because they've been so popular. And as people have been able to refinance out of these more troubled mortgages, they're getting refinanced into agency mortgages. It's sucking supply right out of the system. So, everybody's competing for fewer of them. And if you run big funds like a handful of the really good managers do, they can't build as big of positions as they would have like to or they once could have. So, most of them do not have huge positions in non-agency mortgages, despite the fact that they've got that capability. This fund being relatively small, the shop itself being relatively small, they have a lot of research resources they can bring to bear, and they're able to have a relatively small fund that's really chock-full of these non-agency securities.
Benz: This fund is Angel Oak, and you know that the managers actually have an interesting background that you think situates them well to investigate this pretty arcane portion of the bond universe. Let's talk about that.
Jacobson: Not to take away from anybody else in the industry--because there are some brilliant people managing non-agency mortgages at some of these other firms--but what I found really interesting about these guys is that many of them come from the banking sector. And when I say the banking sector, I don't mean the Wall Street banks necessarily, but banks that actually underwrote a lot of the non-agency mortgage securities. So, there are a lot of details and little interesting twists and turns. Some of it has to do with just the basic underwriting; some of it has to do with these weird structures that we don't see anymore in new issuance but were really hot back in the bubble period, [such as] option ARMs [adjustable rate mortgages], all kinds of crazy things that people could do--take equity out, and so on. Lots of things that need deep, deep research to understand. These guys know it from the other side.
Benz: So, you want someone who is versed in this particular space. A question, though: You mentioned that it was a tremendous buying opportunity coming out of the financial crisis and returns have been very good for the subset of funds that have focused here, but how about on a going-forward basis? I know I'm asking you to make a market call about the non-agency-backed mortgage universe, but should people be as bullish on this area going forward?
Jacobson: I think the answer to that is probably not. It's not so much a market call on my part as it is a recognition that, as you say, they did really, really well over the last several years. And essentially, what's happened is it has sort of normalized the sector a little bit. At one time, we had things pricing out at $0.40, $0.50, or $0.60 on the dollar. As those things improved over the past few years, they were throwing off fat yields--they had a lot of time to perform and do well. There do appear to still be some opportunities. Again, some of it is because there are not a lot of players still in this area, partly because it's shrinking too. Nobody's going to go and build a brand-new team and say, "We're going to go into this space," when there is very little supply. But my understanding is that we're at that point where there's still enough value, especially relative to other things in the bond market that are so tight and yields are so small. There's still something that you can earn out of these that gives you an advantage over the highest-quality bonds especially.
Benz: The last idea is Hotchkis & Wiley High Yield. I know this is one that we've followed for a while now. Let's talk about why you think it merits a second look.
Jacobson: Right out of the gate, we like the managers. These are a couple of guys who worked at PIMCO for a long, long time--sometimes [they worked together and then] there were periods of time when they didn't. It's interesting because they both, at one time or another, headed up the high-yield group at PIMCO. And that gave them a lot of experience running very large funds--not only knowing high yield really well, but knowing the limitations of size. So, going to Hotchkis & Wiley gave them some really interesting advantages in terms of the size of the portfolios that they're running, and now it's been sort of a growing process since they first got there. When they started out, they were almost exclusively using stock analysts to help them do analyses of these small or high-yield bond deals, but they've grown their team. It's evolved. I think they're still doing pretty well, and this combination of reasonable costs and a small asset base--which is really helpful for a high-yield fund--and two really, really experienced managers running this thing. It's just a real interesting option.
Benz: Now, I know they tend to be different flavors of high-yield bond funds. Some tend to be a little more conservative in terms of their credit quality; some are more pedal-to-the-metal types. Where would you characterize this one on that spectrum?
Jacobson: These guys tend to lean a little bit higher quality in terms of their history, but I think that they've been a little bit more opportunistic in the last few years. They've had a stumble here and there. I think 2011 was a little bit of a rough year; they had some issues, but nothing terrible. Again, the size issue is really interesting from that perspective because normally speaking you have the option to go down, as I said before, into smaller deals. They don't dip too far down, but you always have more of a liquidity premium built in, the smaller you go. And that's a double-edged sword.
On the one hand, when I say "liquidity premium," really what I mean is a little extra income that you can get off of those bonds. On the other hand, you're earning that because you're taking on some liquidity risk, and they may not perform as well in a downturn. Again, I think part of the story here is that [the managers] seem to be doing a really nice job of balancing those traits out in the portfolio. They're not running in one direction or another.
Benz: Eric, thank you so much for being here to share these off-the-radar bond ideas.
Jacobson: My pleasure, Christine. Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.