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.
S&P: How have the components of your portfolio changed over the past year?
GUNDLACH: At the beginning of 2003, everything in the mortgage-backed securities market was priced at a premium (above par) since rates were so low. In early 2003, we were invested heavily in adjustable rate mortgage-backed securities knowing the rate environment would probably change.
By the end of 2003, the fund had 31.8% of its assets invested in adjustable rate mortgages, 29% in CMOs, and 27.3% in pass-throughs. At the end of March 2004, we had 32.2% in CMOs, 29.9% in adjustables, and 25.3% in pass-throughs.
S&P: How have mortgage-backed bonds performed recently?
GUNDLACH: Bond returns, as a whole, were low in 2003 and will likely fall further this year. Through the end of April, the Lehman Aggregate Index, government bonds and corporate bonds have all been essentially flat, while mortgage-backed securities were nominally up. What distinguishes mortgage-backed securities is that they have lower volatility.
S&P: What advantages does a mortgage-backed securities fund have over a more diversified bond fund?
GUNDLACH: Mortgages have the highest risk-adjusted returns of any asset class. Mortgage-backed securities tend to outperform other bond sectors on a risk-adjusted basis — regardless of the market environment — because of their relationship between yield (return) and duration.
Today, mortgage-backed securities yield about 5.5%, while the duration is 4, a ratio of about 1.3. By comparison, Treasuries have a yield of 3.5% and a duration of 5.4, a ratio much worse, below 0.7. Corporate bonds yield 4.5%, but their duration is 6. The ratio is again below 1.
This relationship — return to volatility — is consistent over time, and is most attractive for mortgage-backed securities.
S&P: Why have you outperformed other mortgage-backed securities funds over the short and long term?
GUNDLACH: It is because of our focus on less prepayment risk, and less extension risk when rates go up. Our assumption is that investors who take on above-average prepayment risk are, on average, in a losing proposition. This is also why our fund has a far lower turnover rate than our peers.
S&P: What is your view on interest rates?
GUNDLACH: It’s clear that we’re looking at a period of rising interest rates and rising inflation over the next few years. This presents bad news for all bond funds in the short term, but less so for my fund.
Consider this: Rates bottomed on June 13, 2003. Since that time through April 30 2004, rates increased by 150 basis points. Over that period, the PIMCO Total Return Bond Fund was down 0.2%; the Vanguard Ginnie Mae Fund declined 0.2%, while our fund rose by 1.4%.
Bonds will all drop in price when rates rise. But by how much? The answer is duration. Our fund typically has a lower duration than the PIMCO fund, and similar duration to the Vanguard fund.