Bond Funds Are Victims of Timing

Thinking Worst Was Over,
Top Performers Now Lag Behind

By TOM LAURICELLA
November 17, 2007; Page B1

After successfully dodging the bond-market storm earlier this year, several big mutual funds thought the worst was over. It was a bad call, and now they're feeling the pain.

The result: Some funds with great long-term track records -- including funds from Capital Research & Management's American Funds, and Legg Mason Inc.'s Western Asset Management group -- have taken significant hits in just the past month or so. Some that have long been top performers are now posting below-average returns and lagging behind the broad bond market by anywhere from one to nearly five percentage points, a huge gap for bond funds.

Some of these funds used a "bull-market strategy" of buying on a dip, says Jeffrey Gundlach, manager of one bond fund that has largely avoided the recent damage. That strategy "doesn't work in a bear market," he says.

Mr. Gundlach's TCW Total Return Bond Fund, which focuses on mortgage-backed securities, continues to shy away from investments tied to lower-quality mortgage securities. That's help lead to a 6.9% gain so far this year, beating 97% of the competition.

Similarly, Pacific Investment Management's Pimco Total Return Fund, managed by Bill Gross, has steered clear of investments like these and has maintained its track record.

The funds doing the buying took small positions in battered bonds backed by subprime mortgages, or in debt issued by beaten-down mortgage lenders such as Countrywide Financial Corp. In general, mutual funds have steered clear of the risky mortgage-backed-securities market, which has inflicted tens of billions of dollars of losses on Wall Street giants including Merrill Lynch & Co., Bear Stearns Cos. and Citigroup Inc.

Indeed, bond-fund managers in general take credit for being better than these giant Wall Street firms at spotting the early-warning signals a year or two ago of housing-market trouble. They say it was clear to them, for instance, that lenders were making it too easy for borrowers to get mortgages by offering, no-down-payment loans to buyers with poor credit.

There were warning signs in other parts of the bond market, too, suggesting that the prices on riskier securities were vulnerable to big declines, says Tad Rivelle, a portfolio manager on the Metropolitan West Total Return Bond Fund. "We recognized that the corporate-bond market, the high-yield market, as well as the subprime market" were all making borrowing too easy.

Perhaps the most vocal warning was issued by Mr. Gross of Pimco, a unit of Allianz SE. In 2006, Mr. Gross began worrying about the impact that a collapse in the housing market would have in 2006 and repositioned his portfolio toward lower-risk investments. It turned out that he was early in his prediction, and as a result his fund's performance fell far behind through the first half of this year. Now, however, his Total Return Fund is beating 97% of rival funds so far this year with a 7.1% gain, 1.3 percentage points ahead of the benchmark Lehman Brothers Aggregate Index.

"When the tide goes out, you get to see who's swimming naked," Mr. Gross says.

"Pimco has had its bathing suit on for a long time," Mr. Gross says, expecting a housing downturn and a deterioration in mortgages and derivatives related to that.

In late summer, the bond markets were roiled by the credit crunch and prices fell sharply for mortgage-backed securities, as well as bonds issued by mortgage lenders and high-yielding corporate debt.

It was around that time when some bond-fund managers felt the declines were starting to look overdone. American Funds' $35 billion Bond Fund of America, which is ranked among the top 5% of its Morningstar Inc. category for the past five years, was among them.

For example, five-year debt from Countrywide had fallen significantly in price so that its yield went from about 0.50 percentage point above comparable maturity Treasurys to as high as 5.5 points above Treasurys.

It was much the same story for debt issued by Residential Capital LLC, or ResCap, a unit of GMAC Financial Service. Bond Fund of America also added some ResCap holdings.

Making similar moves was Western Asset Management, the country's biggest bond manager. The firm's Core Bond fund had already been lagging behind, in part owing to the firm's typical strategy of holding more corporate and market-backed bonds and less of lower-yielding Treasurys, which were rallying. Western added subprime debt, as well as bonds from Countrywide and ResCap.

For a while, it looked smart: Countrywide's bonds rallied so that the yield hovered around two percentage points above Treasurys, and there was a slight rebound in subprime prices. Then, in late October, the mortgage market imploded a second time. The ABX index tracking triple-A mortgages -- the highest-rated kind -- collapsed from around 95 to the high 70s. Countrywide fell back to about five percentage points over Treasurys, where it remains.

"We thought we had a pretty conservative position," says James Hirschmann, chief executive of Western.

Compounding the woes related to the mortgage market, Western also suffered as corporate bonds were hit to a similar degree. The two markets don't generally move in lockstep, in the recent downturn they did, says Mr. Hirschmann.

Meanwhile, Bond Fund of America is lagging behind 74% of its rival funds, and is returning 2.3 percentage points less than the Lehman Aggregate index in 2007.

Some managers who stayed clear of subprime, such as Mr. Rivelle, as well as those at BlackRock Inc., are now dipping their toes in the water.