Taking Measure of Two Bond Giants

As part of the due diligence Morningstar fund analysts perform on the funds and fund families we cover, we regularly visit fund companies. In mid-January, a few colleagues and I flew out to Los Angeles to visit two of the largest players in the fixed-income marketplace: PIMCO (which had nearly $750 billion in assets under management at the end of 2008, including $132 billion  PIMCO Total Return (PTTRX)) and Western Asset Management ($586 billion in assets, including funds in its own name, and those it runs for parent Legg Mason). The meetings we had at the two firms proved to be a study in contrasts, and in some respects this was underscored by how each firm fared in 2008's brutal market for bonds.

Take It From the Top: A Snapshot of Organizational Change
Both PIMCO and Western have seen significant changes at the top of their organizational structures, but for different reasons. In PIMCO's case, back in 2007, the firm's leadership anticipated the need to provide strong and credible succession planning for both then CEO Bill Thompson and for CIO Bill Gross. In an unconventional move, the firm hired former managing director and senior portfolio manager Mohamed El-Erian, then president and CEO of Harvard Management Company to serve in the new combined position of Co-CEO and Co-CIO beginning January 2008.

El-Erian had taken over as head of Harvard Management in February 2006, after working at PIMCO for seven years. During his short tenure there he rebuilt the university's endowment investment staff, which had suffered when former head Jack Meyer left to found hedge fund Convexity Capital, taking 33 investment professionals with him. El-Erian's return to PIMCO was clearly positive for the firm, as in addition to being widely considered one of the leading investment minds around, his academic and governmental experience made him well-qualified for the new role. Thus, in September 2008, when Thompson announced his retirement at the end of that year, we already knew PIMCO was in good hands.

Western's situation was different, in part due to the circumstances surrounding the change of its chief investment officer in late summer 2008. In August 2008 Western's longtime (and highly respected) CIO, Ken Leech, stepped down from heading the firm for medical reasons, and he was replaced by then deputy-CIO Steve Walsh. At that time, Leech and Walsh had served in these positions since 1990 and 1991, respectively, so the change did impact a longstanding leadership structure. Moreover, while Leech has still been able to take part in the investment discussion from his new position as emeritus CIO, his full presence as head of the firm is still clearly missed by many. Also, Western has yet to name Walsh's deputy, and these changes at the top take place in the context of broader organizational change at the firm.

One example of this organizational change came at the end of 2005, when Legg Mason swapped its brokerage unit for Citigroup Asset Management, which added $400 billion in assets under management to the firm, many former Salomon Brothers and Smith Barney legacy funds, and a slew of investment personnel. Western initially decided to retain all the Citigroup managers to allow for some continuity during the acquisition's integration; however, by late 2007 the firm saw some overlap in investment personnel resulting from the acquisition and eliminated eight portfolio managers and analysts from their New York office, in addition to several other departures that occurred since the acquisition.

This is not to suggest that manager turnover has been absent at PIMCO, but with the exception of a few high-profile departures in recent years, such as TIPS manager John Brynjolfsson, global bond manager Sudi Mariappa, and high-yield manager Ray Kennedy, we've seen good stability among the investment personnel there. In the end, while the circumstances surrounding the CIO changes at PIMCO and Western were very different, PIMCO appears to have been better set up organizationally to weather 2008's storms. For Western's Walsh, August 2008 (roughly a month prior to the Lehman Brother's implosion, which would touch off the worst quarter ever for many fixed-income sectors) was an unfortunate time to take on his new role. Clearly, tackling organizational changes in the midst of financial market meltdown is less than ideal.

The View from 30,000 Feet
One very significant difference between PIMCO and Western heading into 2008 was the macroeconomic outlook predominant at each firm, which of course would have profound investment performance implications during the financial crisis. Western's outlook in mid-2007 (when the crisis was still in its early stages) is perhaps best captured by an uncomfortable exchange between Walsh and  FPA New Income (FPNIX) manager Bob Rodriguez during the fixed-income panel of the Morningstar Investment Conference that year. The issue at hand was whether taking on credit risk was appropriate at the time, given that many credit sector yields were close to historically narrow ranges relative to comparable maturity Treasuries, indicating to Rodriguez that these parts of the market offered little value for their risks. Walsh disagreed, arguing that Western was still finding some good opportunities in the credit markets at that time.

And in fact, Walsh later admitted that Western's two greatest errors heading into 2008 were adding to credit sectors too early, as prices declined and yield spreads widened, and adding to subprime-exposed non-agency mortgage securities to the extent the firm did. This latter move was particularly painful, as related by structured products team leader Ronald Mass, as the firm was well aware of the increasing trouble in the subprime mortgage space but thought that it was protected by purchasing the highest-quality securities in that sector, which seemed to be offering good value. Of course, fears over rising delinquencies, expected defaults, and losses, in the wake of a dramatic nation-wide housing price collapse, would soon overshadow the protection these securities appeared to offer and their prices declined too.

It's important to point out that this comparison in firm styles is certainly not an apples-to-apples comparison. Western has long focused on credit sector betting, and in contrast, PIMCO has traditionally been more reserved in that area, focusing more on other factors, such as taking on interest-rate risk. Nevertheless, PIMCO's macro outlook was notably more dour over the prospects of credit sector performance in 2007 and 2008, and the firm positioned itself well by avoiding much of the credit market's trouble. In his April 2007 Investment Outlook, for example, Gross argued, "The problem with housing, however, is not the frequently heralded increase in subprime delinquencies or defaults� but the tightening of credit conditions that are in part a result of those losses." In the same article he argued that if mortgage rates didn't substantially decline, home prices would have to drop (even dramatically) to bring housing supply and demand back into balance. As a result of weakness in the housing sector, which PIMCO thought would impact the economy overall, Gross believed that "the Fed will cut rates and cut them significantly over the next few years in order to reinvigorate an anemic U.S. economy," and the firm positioned themselves for just such an eventuality. Of course, this style redounded to PIMCO Total Return's advantage in both 2007 and 2008, when the fund's high-quality (it and other PIMCO funds largely avoided subprime debt and the worst of non-agency fare) and added interest-rate sensitivity, among other factors, drove strong results.

Meanwhile, both  Western Asset Core Bond (WATFX) and  Western Asset Core Plus (WACIX) suffered due to declines in their non-agency mortgage stakes (roughly 19% and 16% of assets, respectively), in other credit sectors, and also suffered from selected corporate-bond miscalls, notably Lehman Brothers and Iceland's Kaupthing Bank, Glitnir Banki, and Landsbanki, now all in default. The funds' performance was also impacted due to a degree of effective leverage in the portfolios; however, I'll leave that part of the story to my colleague Eric Jacobson, who will discuss it in a forthcoming article.

The Upshot
When looking at the relative performance across the two fund shop lineups, these differing macro perspectives, and perhaps even the organizational changes, show a sharp contrast in performance. In 2008, many of Western's funds saw bottom-quartile performance, and in some cases unexpectedly steep losses. PIMCO, however, fared quite well with the exception of several funds in the municipal lineup and a few others, and importantly, PIMCO Total Return delivered an impressive 4.8% return in a very difficult year, which ranked the fund near its category's top decile.

Not surprisingly, the divergent results of each firm have resulted in asset inflows at PIMCO and sizable outflows at Western. In fact, Morningstar's Market Intelligence capital flow data service estimates that PIMCO saw $19 billion added across its mutual fund family in 2008 (behind Vanguard with the second-highest amount overall) while Western saw $8.4 billion depart the firm, including near a third of the assets in its Core and Core Plus funds. Asset flows matter to investors because significant redemptions can both force a manager to sell securities when they don't want to and can limit the opportunity a manager has of taking advantage of attractively valued markets, both possible risks Western faces should redemptions continue in 2009.

In the end, our trip reaffirmed the confidence we have in PIMCO's stability, managerial strength, and approach, which are all factors that have helped Gross and his team win three Morningstar Fixed-Income Fund Manager of the Year awards. And while we saw areas of strength at Western too, which could see a recovery in its funds should credit markets stabilize and redemptions cease, it was clearly a shop struggling with some problems.

We are glad to see Western attempt to address some of its issues, though. For example, the firm hired new chief risk office Ken Winston in 2008, who is attempting to improve the firm's risk analytic and quantitative research systems; and the newly promoted global head of credit Mike Buchanan's efforts to improve communication between various sector teams and far-flung offices. Still, it's early to know whether such efforts will gain traction, and as a result my colleague Michael Herbst has taken a more cautious stance on Western's funds of late.