Quick Take: Although the mortgage refinancing business has recently crashed due to higher interest rates, the $208-million TCW Galileo Total Return Bond Fund (TGLMX), which invests exclusively in mortgage securities, has withstood the vicissitudes of refinancing and rates by focusing on moderate duration exposure and minimum credit and prepayment risk.
Under lead manager Jeffrey E. Gundlach, the fund has outperformed its peer group over the short and long term. For the three-year period, it retuned an average annualized 7.4%, versus a 5.0% rise for its peers. The portfolio has also handily beaten its peers for the five- and ten-year periods. In addition, the fund carries a low expense ratio of just 0.44%, versus 1.05% for the peer group.
The fund’s fine long-term performance record recently earned Gundlach and his team a 2004 Standard & Poor’s/Business Week Excellence in Fund Management Award.
The Full Interview:
S&P: What kind of securities do you invest in?
GUNDLACH: Strictly in mortgage-backed securities of any maturity, which are guaranteed by the U.S. government, or in privately issued mortgage-backed securities rated at least AA by Standard & Poor’s. We take no credit risk, nor do we invest in other kinds of fixed-income securities. We invest in relatively cheap securities that provide a yield similar to the overall mortgage sector, but with a lower degree of prepayment risk.
S&P: Would you describe the portfolio currently.
GUNDLACH: As of March 31, 2004, the fund held 67 securities, had an average yield of 5.77%, and an average duration of four years. Our portfolio is constructed to have a weighted average duration of less than eight years.
S&P: What are the fund’s objectives?
GUNDLACH: We like to compare ourselves with the PIMCO Total Return Fund (PTTAX) and the Vanguard GNMA Fund (VFIIX) over rolling three-year periods. We seek to equal or outperform the PIMCO fund’s returns, while providing less risk; and to outperform the Vanguard fund, while keeping a similar risk profile.
S&P: What happened to the mortgage-refinancing boom we experienced a year ago? And how has this affected your fund?
GUNDLACH: The mortgage-refinancing boom was in place until July 2003, coinciding with interest rates bottoming. Prior to this, the mortgage market was very short term; it got down to a duration of about one year at one point, while other bond sectors had a duration of about four years. This difference resulted in much lower volatility and a much lower yield for mortgage-backed securities.
When the refinancing picture changed, the mortgage market started to get longer term. Because we have less risk relative to the variability of prepayments, when interest rates rose in 2003, we were in a position to buy more undervalued securities.
After rates increased, in the latter half of 2003 mortgage-backed securities declined in value. We bought securities trading at substantial discounts to par — at, say, 87 cents on the dollar. These securities tended to be ten-year agency collateralized mortgage obligations (CMOs) backed by 15-year mortgages. By buying cheap CMOs, we minimized exposure to prepayment risk, and positioned ourselves well for the refinancing problems afflicting the mortgage sector.
Relative to other fixed income sectors, our fund benefited from having a low duration since yields rose a bit in 2003.