Dull mortgage bond can lead to thrills

Your Money

August 27, 2006|By Tom Petruno | Tom Petruno,LOS ANGELES TIMES

Longtime shareholders of Jeffrey Gundlach's bond mutual fund have to be thrilled with his investment performance.

Whether many of them could explain how he does it is another matter.

When your portfolio is stuffed with securities such as Fannie Mae Collateralized Mortgage Obligation 04-68-LC, 5 percent, due on 09/25/29, the details don't exactly lend themselves to cocktail party chatter.

Gundlach, 46, has built an enviable record in fixed-income investing: His TCW Total Return Bond fund in Los Angeles runs neck-and-neck over the past 10 years with the Pimco Total Return fund, considered to be the gold standard for bond funds.

Gundlach's forte is mortgage-backed securities, an array of bonds that can make the average person's head hurt trying to understand. Gundlach finds them genuinely interesting. He also is a fan of Sudoku puzzles.

No. 1 rating

For his investors in the $520 million TCW Total Return fund, Gundlach's prowess with mortgage-backed securities translated into a No. 1 performance rating among mortgage funds for the five years and 10 years ended in 2005, according to fund tracker Lipper Inc.

The TCW fund has earned a 7.1 percent average annual return during the past 10 years, matching the return of Pimco Total Return, which is managed by well-known bond market guru Bill Gross.

Gundlach credits his mastery of the bond market to his grounding in theoretical mathematics, his major at Dartmouth College in the late 1970s.

"Mathematical training is really about taking very complex things and seeing what's essential and simple in them," he said. "And there's a lot of that in the mortgage market and, I think, in investing in general."

Gundlach believes that mortgage-backed bonds offer the best opportunity for income-hungry investors to earn a higher yield than on plain vanilla U.S. Treasury securities over time, without taking on extra risk in sectors such as corporate junk bonds or foreign debt.

The idea behind mortgage bonds is fairly simple: Package a bunch of home loans together and issue a bond that's backed by the loans. The principal and interest payments made by homeowners effectively are passed through to the bond investors.

The mortgage-backed securities market now is valued in the trillions of dollars. Its size and complexity have mushroomed with the U.S. housing boom of the past decade.

One popular security is the CMO, or collateralized mortgage obligation. CMOs carve up the cash flow from mortgages - the principal and interest payments - in ways that allow investors to pick and choose theoretical returns and risk levels.

CMOs dominate Gundlach's mutual fund. "What we've tried to do is to turn mortgages into Treasuries, but earn the mortgage yield," Gundlach said of his risk-management strategy.

To put it another way, Gundlach is trying to exploit what he believes are inefficiencies in mortgage securities caused by other investors' more limited understanding of the market.

"There are certain characteristics that occur in those markets that investors just seem to never get," he said.

Gundlach believes that the U.S. economy is slowing sharply and may well trip into recession next year. That raises two potential challenges for mortgage bonds.

One is that long-term market interest rates could continue to slide, spurring another mortgage refinancing wave that could retire many of the highest-yielding bonds earlier than investors had hoped.

But Gundlach said he doubts that long-term rates would fall low enough to fuel a repeat of the major refinancing wave that hit in 2002-2003. So he's more confident about the outlook for sustaining his portfolio's interest income, which now generates an annualized yield of about 4.3 percent.

A second risk is that investors could bail out of mortgage bonds in a panic if, say, they began to worry that mortgage loan default rates could soar.

Risk of sell-off

In 1994, the mortgage securities market suffered a major sell-off when the Federal Reserve doubled short-term interest rates. That temporarily pounded some TCW bond portfolios.

By the end of 1994, the CMO market "was so cheap," Gundlach said. "You can't believe how low it was." It was, of course, a great time to buy.

Although the market's vagaries are always a risk, Gundlach said investors should focus on the fundamentals: In his fund, most of the bonds have top credit ratings.

The securities either are issued and guaranteed by finance giants Fannie Mae and Freddie Mac, or are secured by collateral guaranteed by those companies or by U.S. agencies such as Ginnie Mae, the Government National Mortgage Association.

In other words, Gundlach said, even if more people have trouble paying their mortgages, that isn't a concern for investors who own mortgage bonds backed by credit guarantees - as long as they can stick with them.

Tom Petruno writes for the Los Angeles Times.

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