How Is TCW Doing?

In mid-March, Morningstar analysts met with several TCW portfolio managers and analysts, including co-director of fixed income Laird Landmann, emerging-markets managing director Penny Foley, co-head of securitized products Mitch Flack, and director of credit research Jamie Farnham. We last visited TCW's Los Angeles headquarters in February 2014. Below we provide some provide background on TCW and the conclusions we drew from our visit.

Taking a Look Back

Private equity giant Carlyle Group and TCW management combined to acquire TCW from Societe Generale in February 2013. While the firm saw some non-investment-team employees depart following the deal, the portfolio manager and analyst ranks have remained stable. That said, TCW's corporate culture has undergone a shift since it dismissed Jeffrey Gundlach and acquired Metropolitan West Asset Management to take over several fixed-income strategies, including

MetWest had not run a mortgage-focused fund prior to taking over TCW Total Return Bond in 2009, though its flagship offering,

Metropolitan West Total Return Bond has received the most inflows of any actively managed fixed-income fund following Bill Gross' September 2014 departure from PIMCO. The open-end fund had $64 billion in assets at the end of March 2015, up 88% since last September. In contrast,

The TCW emerging-markets bond team also saw changes in December 2009 when lead manager Luz Padilla and two analysts left. Foley and David Robbins, who'd managed emerging-markets multiasset separate account TCW Worldwide Opportunities, stepped in. Their compact team of four sovereign risk analysts and three corporate analysts was down one corporate analyst as of January 2015.

How Has the Firm Shaped Up? It appears that Carlyle's involvement has not impeded the investment team, which has been able to add staff as necessary. In our meeting, Landmann, who is also a generalist portfolio manager on Metropolitan West Total Return Bond, indicated that there are no near-term plans for an ownership transition. TCW management has ruled out a leveraged buyout of Carlyle's majority ownership stake in the firm. Instead, Landmann mentioned that one possible outcome would be an IPO, which would allow for the investment staff to increase its share of the firm and for Carlyle to make a gradual exit. This would avoid the risks associated with bringing in a strategic buyer who might seek to aggressively cut costs or cause turnover in the investment ranks.

We have also been paying close attention to the integration of the two teams since MetWest was brought in to run TCW Total Return Bond. Though several non-investment-team employees have left, CEO David Lippman seems to be doing a good job of maintaining stability in the investment ranks. He has also pushed for greater collaboration among investment teams. For instance, the emerging-markets bond team's credit analysts now sit on the same floor as MetWest's. These L.A.-based analysts interact with the emerging-markets equity team in New York as well.

All told, the legacy MetWest team seems stable. Morale may be weaker among legacy TCW teams, which are largely managing equity assets given that these teams have experienced the most change; that could warrant closer scrutiny.

Basking in PIMCO's (Diminished) Glow

Metropolitan West Total Return Bond has been one of the biggest beneficiaries of outflows from the post-Gross

A related issue is whether the inflows will impede the fund's successful investment process. Morningstar has noted the fund's shrinking stake in less-liquid nonagency mortgages (to 11% at the end of last year from 14% as of mid-2014), raising the concern that the fund's size has crowded it out of that niche. Landmann argued that the reduction reflected full valuations given nonagencies' strong recent performance, not capacity constraints. However, the team upgraded the credit quality of the nonagency stake during the past two years, and adding to that position may have been harder in the current environment. The portfolio's biggest change since last October was an increase in its U.S. government bond stake to 33% from 27%.

Landmann argues that Treasuries offer the most compelling risk/reward profile given late-stage credit-cycle dynamics, though clearly this was an easy source of liquidity. The fund's exposures to corporates, asset-backed securities, and commercial mortgage-backed securities stayed roughly the same. A ballooning cash stake would have been concerning, but that position halved to 3% over the six months through the end of March. All told, the team has dealt with the flows reasonably well, though we will continue to monitor its ability to traffic in less-liquid markets.

Struck by Energy's Swoon It's been a rough year for Metropolitan West High Yield Bond. The fund has maintained a significant exposure to energy during the past couple of years, with roughly 22% of the fund invested there before oil prices plunged in late 2014. (The Barclays U.S. Capital High Yield Index had about 15% in energy.) The team had devoted the bulk of this exposure to exploration and production and midstream companies with light exposure to servicers, citing strong asset coverage in the former group. Though the team acknowledged that it did not have an adequate stress test for the price of oil, it doesn't think oil prices can stay in the $40-$50 range given the supply/demand mix and has stuck with the overweighting.

In light of the recent misstep in energy and earlier struggles attributable to the fund's cautious credit stance, we are going to apply close scrutiny to this team's positioning decisions and resulting performance.

TCW's Emerging-Markets Team Is Compact but Remains Compelling

The team behind

Though it's seen some outflows during the past two years, TCW Emerging Markets Income is the fourth-largest emerging-markets bond fund, with $4.4 billion as of March 2015. Foley acknowledged that the larger asset base and liquidity challenges in the markets require more diversification today. Specifically, the team limits high-yield positions to 50 basis points or less and does not own more than 15% of any individual issue. It also sticks to high-quality fare and limits exposure to distressed debt. As the fund grows, Foley and the team plan to keep the focus on cash bonds, with only modest use of derivatives to hedge currency.

Over time, Foley and her team have skillfully allocated across the hard and local currency segments of this market. Despite the recent departure, the experience of the managers and key analysts involved in this fund remains impressive. As a result, we upgraded the fund's Morningstar Analyst Rating to Silver from Bronze.