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Nominees for 2014 Fixed-Income Fund Manager of the Year

There were many surprises in 2014's bond markets, but a few managers got it right.

Earlier this week, we announced nominees for Morningstar's Domestic-Stock and International-Stock Fund and Manager of the Year honors. Next up are the Fixed-Income Manager of the Year nominees. (Nominees in the allocation and alternatives categories will be revealed next week, and all winners will be announced on Jan. 21.)

A drop in the long end of the yield curve caught many bond managers off guard in 2014 as the yield on the 30-year U.S. Treasury rate dropped to 2.75% as of Dec. 31, from just under 4.00% at the start of the year. Although the Federal Reserve ended its quantitative easing program in October and is widely expected to raise short-term rates in 2015, long-term bond yields continued to fall, helped by low inflation in the U.S. and a slowing global economy. These forces gave a boost to U.S. Treasuries, even at historically low yields. Several of the managers nominated this year benefited from an overweighting to long-maturity bonds when most of the market was betting on an increase in long-term bond yields.

The bond market had several other surprises in store for investors. The steep and (largely) unexpected drop in oil prices in the second half of the year sent ripples across the markets. Because the percentage of energy companies in the junk-bond market has increased over the years as the shale boom in the United States significantly increased that sector's need for capital, high-yield funds were hit hard in the back half of the year. Finally, ongoing turmoil in Russia, which intensified in mid-December, caused a sell-off in the broader emerging-markets space.

The ebb and flow of the bond market, especially in December, caused some managers and funds to look great one week and not so great the next, highlighting the importance of a sound strategy and a longer-term outlook. Although a strong showing in 2014 is an important criterion in selecting our nominees, we also want to recognize managers who have delivered superior long-term returns with strategies that continue to earn our analysts' confidence. As a result, all nominees have earned a Morningstar Analyst Rating of Gold, Silver, or Bronze, indicating that Morningstar's analysts believe the funds will outperform their peers on a risk-adjusted basis over a full market cycle.

This year's nominees for Fixed-Income Fund Manager of the Year are:

Ken Leech, Carl Eichstaedt, and Mark Lindbloom, Western Asset Core Bond WACSX and Western Asset Core Plus Bond WAPSX

2014 Returns: 7.38% and 7.68%

Morningstar Category Ranks (Percentile): 4 and 3

Led by Western Asset CIO and head manager Ken Leech, this is a team that has bounced back nicely after a rocky 2008. Since then, the firm made a number of improvements to both risk management and its investment processes and strengthened its resources across the board. The team has quietly re-established topnotch records--both Western Asset Core Bond and Western Asset Core Plus Bond land in the top quartile of the intermediate-term bond Morningstar Category for the trailing five- and 10-year periods ended Dec. 31.

At the core of the fund's 2014 success was a contrarian call at the beginning of the year. When many in the market thought rates were sure to rise, Leech and his team positioned the funds with a longer duration than those of its Barclays U.S. Aggregate Bond Index benchmark and many of its peers. As long-term rates declined through the year, the funds' 7% returns for the year bested more than 95% of peers and topped the index by more than 100 basis points. The funds also got good mileage out of stakes in agency and nonagency mortgages and a short position in the euro.

While the funds' willingness to hold positions in high-yield bonds and nonagency mortgages can court plenty of risk, the team deserves credit for carefully negotiating a variety of markets since 2008 and notably sidestepping trouble in 2011's rocky bond markets.

Steve Smith, David Hoffman, and John McIntyre, Legg Mason Brandywine Global Opportunities Bond GOBAX

2014 Return: 6.26%

Morningstar Category Rank (Percentile): 12

Steve Smith and David Hoffman have run Legg Mason Brandywine Global Opportunities Bond since its late-2006 inception, and despite recent weakness in some of the fund's emerging-markets stakes, its long-term track record remains impressive. Through Dec. 31, the fund landed in the top decile of its world-bond category since inception.

The fund stands out for its willingness to diverge significantly from market-cap-weighted global indexes, which lean heavily toward developed markets. Instead, the fund has held large stakes in emerging-markets debt and currencies, and global fixed-income markets have offered plenty of potholes this year. The emerging-markets shakeup in the fourth quarter hurt the fund because of its larger-than-average stake in those bonds, including a midteens stake in Mexico. That said, the fund has mostly avoided the yen and euro for years, which helped it top more than 85% of its peers with a 6% gain in 2014 as those currencies slid versus the dollar. A well-timed moved into longer-dated U.S. Treasuries also gave the fund a boost during the year.

Michael Garrett, Vanguard GNMA VFIJX

2014 Return: 6.76%

Morningstar Category Rank (Percentile): 1

Wellington Management Company has subadvised this fund since its 1980 inception, and manager Michael Garrett has been involved with the fund since late 1999. After a brief stint overseeing the Fed's agency-mortgage purchase program in 2009, Garrett took over as lead manager in 2010.

Rising bond yields and the Fed's tapering of asset purchases pumped volatility into the Ginnie Mae market in 2013. In 2014, markets were calmer and rates rallied, giving a boost to mortgage funds. Vanguard GNMA prospered in that environment, outpacing all of the funds in its intermediate-term government category and its Barclays U.S. GNMA Index. Citing relatively steep valuations in Ginnie Mae mortgages, Garrett made modest allocations to Fannie Mae and Freddie Mac debt while underweighting lower-coupon fare, all positives for the fund during the year. A stake in longer-duration collateralized mortgage obligations and Treasuries also benefited as long-term bond yields rallied sharply.

The fund's long-term track record is also impressive. Over the trailing three-, five-, and 10-year periods, the fund's returns landed in the top quartile of peers.

Bill Irving and Franco Castagliuolo, Fidelity GNMA FGMNX and Fidelity Government Income FGOVX

2014 Returns: 6.26% and 5.43%

Morningstar Category Ranks (Percentile): 5 and 22

Longtime manager Bill Irving and comanager Franco Castagliuolo work closely with Steve Langan and a team of dedicated traders to ferret out opportunities in the government-bond markets. The group is backed by the usual Fidelity resources, which include proprietary analytics that allow the team to analyze the mortgage pools underlying each security as well as a structured-products and macroeconomic group that helps keep a close eye on Fed policy.

Unlike many competitors, the team here sticks to government-backed fare with these funds and eschews interest-rate bets, instead focusing on identifying pockets of relative value in the government-bond markets. During 2014, the funds beat the bulk of their intermediate-term government category peers, while Fidelity GNMA fared well relative to most of the Ginnie Mae competition and its Barclays U.S. GNMA Index. Both funds got particularly good mileage from an overweighting to prepayment-resistant mortgages, including those with relatively low remaining balances, as well as stakes in reverse mortgages and a modest dose of leverage. Fidelity Government Income, which has a wider mandate, also benefited from positions in less-traveled corners of the market, such as Freddie Mac multifamily mortgages.

The funds' long-term records are also impressive. Fidelity GNMA landed in the top decile for the five- and 10-year periods ended Dec. 31, while Fidelity Government Income outpaced more than 70% of its peers in the same periods.

Honorable Mentions Several funds didn't make the official nomination list but still deserve recognition. The first two are relatively recent winners of Morningstar Fixed-Income Manager of the Year honors. Fund Manager of the Year repeats are rare, and Morningstar has never named the same manager in back-to-back years, but strong performance in 2014 makes these managers worthy of mention.

Dan Ivascyn and Alfred Murata, PIMCO Income PONAX

Dan Ivascyn and Alfred Murata were named Morningstar Fixed-Income Fund Managers of the Year in 2013 and enjoyed another strong run in 2014. Under Ivascyn and Murata's direction, PIMCO Income has benefited from a signature stake in nonagency mortgages, including exposure to commercial mortgages and a mix of prime, Alt-A, and subprime residential debt. Exposure to that sector has helped it to top-quintile three- and five-year returns as of mid-December and was an important contributor to the fund's strong performance in 2014. The fund benefited from other bets last year, including short exposure to the yen and the euro and a stake in Australian debt.

Mark Kiesel, PIMCO Investment Grade Corporate Bond PIGIX

Longtime manager Mark Kiesel was named Fixed-Income Manager of the Year in 2012 and has deftly navigated this fund through a variety of murky credit markets. For example, a defensive positioning heading into the credit crisis, including buying protection on select homebuilders and retailers via credit default swaps, kept the fund in the black during 2008, even as its benchmark and its average corporate-bond rival lost ground. Kiesel then shifted gears at an opportune time, scooping up the debt of battered cyclicals. Such moves catapulted the fund ahead of the index when corporate bonds surged in 2009 and early 2010. The fund's overweighting to energy bonds in 2014 detracted from returns, even though Kiesel prefers bonds issued by pipeline firms that have less exposure to commodity prices. Kiesel did underweight precious-metals bonds, which helped boost relative performance. The fund's significant allocation to bonds with five- to 10-year maturities also boosted returns as those rates dropped throughout the year. The fund finished the year with a topnotch record relative to its corporate-bond peers and its Barclays U.S. Credit Index benchmark.

Rick Rieder and Bob Miller, BlackRock Total Return MAHQX

BlackRock employs a lot of resources at BlackRock Total Return, and it shows. Managed by Rick Rieder--who joined the firm and the fund in 2009--and Bob Miller, the fund boasts big sector-specialist teams across global interest rates, securitized assets, and corporate credit. Rieder and team marry the firm's macro outlook with bottom-up findings of the sector teams, shooting for an optimal mix.

Rieder's record here is impressive: The fund's trailing three-year returns through Dec. 31 topped more than 95% of its intermediate-term bond peers. The fund fared particularly well in 2014, thanks to an overweighting to long-maturity bonds, a contrarian call for which Rieder deserves credit. Exposure to long-dated municipal bonds and securitized assets also aided returns this year. Indeed, strong performance during the year, an impressive strategy, and the depth of the firm's analyst roster helped secure the upgrade of the fund's Analyst Rating to Bronze. However, while we like this fund's prospects, we generally look for a longer-term track record in awarding Fund Manager of the Year honors.

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