How TCW Galileo Gets Stellar Returns
Mortgage-backed funds have delivered steady returns over the past three years as many other asset classes suffered heavy losses. In general, mortgage-backed securities funds are much less volatile than other types of bond funds because they're less sensitive to changes in interest rates.
Managers of mortgage funds do have to keep a sharp eye on something called prepayment risk, however. With interest rates at historic lows, returns on mortgage securities can be hurt when homeowners refinance at lower rates or pay off their mortgages sooner than scheduled.
The managers of TCW Galileo Total Return Bond Fund (TGLMX) -- Jeffrey Gundlach, Philip Barach, and Frederick Horton -- focus on investing in securities with less overall prepayment risk. The portfolio gained 9.8% for the 12-month period ended November, while the average mortgage fund rose 6.2%. For the three-year period ended November, TCW Galileo Total Return gained an annualized 10.7%, vs. 7.8% for the peer group. (By comparison, the most famous bond fund, William Gross' gigantic PIMCO Total Return Fund (PTTDX), rose 5.2% for the 12-month period, and 9.3% annually for the last three years.)
Based on TCW Galileo's stellar results and risk profile, Standard&Poor's upgraded its overall ranking of the fund in August, 2002, to 5 STARS from 4. It's worth noting that though the portfolio changed its name from TCW Galileo Total Return Mortgage-Backed Securities Fund in May, 2002, it remains a mortgage fund through and through.
Palash Ghosh of S&P's Fund Advisor recently spoke with Gundlach about investing in the sector and the fund's strategy. Edited excerpts from their conversation follow:
Q: Are you permitted to invest in other types of fixed-income securities? The portfolio appears to be almost entirely composed of mortgage-backed securities.
A: We are permitted to invest certain portions of the fund in fixed-income securities other than mortgages. However, we have never done so and are not contemplating such investments at present.
Q: Why are mortgage-backed securities, which now account for the largest portion of the fixed-income market, the most attractive bond investment now in your opinion? Is it primarily their low credit risk?
A: There can be no disagreement that mortgage-backed securities have been the most attractive bond investment historically, based on statistical analysis of risk and reward. Mortgage-backed securities have displayed much higher Sharpe ratios than Treasuries, corporates, or high-yield bonds over time. The reason for the higher Sharpe ratios is that the mortgage-backed securities sector has delivered returns equal to or greater than the other sectors and has done so with lower volatility.
Looking forward, we can estimate prospective risk/reward outcomes by comparing the yields and durations of the various market sectors using available statistics from index providers. To summarize, this data suggests that the future should resemble the past, with mortgage-backed securities continuing to exhibit superior Sharpe ratios.
The fact that superior risk-adjusted returns are offered by mortgage-backed securities is the primary reason to view them as currently attractive. If this return profile can be achieved with the added comfort of not having to worry about credit losses, so much the better.
Q: Are you completely bearish on corporate bonds right now? If so, why?
A: I'm not completely bearish on corporate bonds, but I'm not completely bullish on them either. The trouble with corporate bonds right now is twofold: First, we remain in an environment of high defaults and persistent downward revaluation of corporate health. This suggests that the risk of "blow-ups" remains high and that corporate bonds continue to be a poor choice as a diversifier for equity exposure in a balanced portfolio. Second, corporates as a sector have a very high duration. This suggests that rising interest rates would cause significant price deterioration in corporate-bond portfolios.
These two considerations put together create a situation where it's difficult to see corporates truly thrive. If interest rates remain low, presumably it will be because the economy remains weak, and therefore credit risk remains high, thereby sustaining a negative default trend. Conversely, if credit health improves overall, it would presumably occur in a strengthening economic environment, which would put upward pressure on interest rates. That would negatively affect corporates due to their long durations.
Q: How would mortgage-backed securities fare in comparison, given a rise in interest rates?
A: No fixed-income investor should expect strong returns on an absolute basis when interest rates rise significantly. However, on a relative basis, one can expect mortgage-backed securities to perform well in such an environment. The reason is that mortgages have the shortest duration of any bond sector, which makes them the least volatile and therefore the least vulnerable to price deterioration as interest rates rise. An analysis of historical results supports this view.
Q: What's your approach to the portfolio relative to the index?
A: We attempt to position ourselves to have less prepayment risk than the generic mortgage-backed securities sector. Our pass-throughs [or mortgage-backed securities] tend to avoid moderate-premium 30-year securities and instead hold adjustable-rate pass-throughs, prepayment penalty pass-throughs, 15-year and 20-year pass-throughs, and discount or current coupon pass-throughs.
Q: Do you typically keep a low exposure to privately issued mortgage-backed securities?
A: We typically invest the great majority of the fund in government or agency-backed securities. The nonagency securities we hold are all AAA-rated. Their rating comes not from a guarantee, but instead from a senior position within a senior/subordinated structure. The exposure to these AAA-rated, nonagency, mortgage-backed securities is currently about 18%, a fairly normal percentage for the fund.
Q: How are you coping with the fact that rates on home mortgages are reaching all-time lows, and how do you deal with refinancings? Is it possible to minimize the risk involved in prepayments?
A: It's true that mortgage interest rates are at multidecade lows and that refinancing is at record highs. This environment exposes mortgages to a heightened reinvestment risk. We cope with this risk by investing in securities that have much less overall prepayment risk than the generic mortgage indexes. It's not at all impossible for mortgage-backed securities funds to deliver positive returns in this environment.
We have relatively low exposure to moderate-premium pass-throughs that comprise a large portion of these indexes. Instead, we favor collateralized mortgage obligation (CMO) securities with lock-outs from prepayments for many months, even if interest rates remain at these levels. We also invest in pass-throughs that have reduced refinancing response compared to standard newly issued 30-year pass-throughs. These would include 15-year mortgages and prepayment-penalty mortgages.
Q: How does the fund's average duration and average yield compare with its benchmark? Do you try to keep these characteristics close to that of the index?
A: Our primary benchmark is the Lehman Aggregate Index. Our secondary benchmark is the Lehman Mortgage Index. We think of our goal as outperforming both the PIMCO Total Return Bond Fund and the Vanguard GNMA Fund (VFIIX) over rolling three-year time frames.
The yield of the fund is typically similar to that of the Lehman Mortgage Index, which is typically similar to that of the Lehman Aggregate Index. The duration of the fund typically lies between those of the Lehman Aggregate and the Lehman mortgage-backed securities indexes. This means the fund's duration is typically less than that of the Lehman Aggregate index and greater than that of the Lehman mortgage-backed securities index.
Consistent with these facts, the fund's beta is less than 1 when compared to the Lehman Aggregate Index, but greater than 1 when compared to the Lehman mortgage-backed securities index. The current duration of the fund is 2.65, just about midway between 3.8 for the Lehman Aggregate and 1.1 for the Lehman mortgage-backed indexes.
Q: The fund had a turnover rate of 24.8% for the 12-month period ended September 30, 2002. What is it typically?
A: Our annual turnover rate is typically about 30%, and has been slightly lower than that over the past 12 months. Our approach is to buy relatively "cheap" securities that provide a yield similar to the generic mortgage sector, but a lesser degree of prepayment risk.
The goal is to structure portfolios to be better equipped to withstand interest rate and prepayment volatility. Achieving this does not require high portfolio turnover. In fact, we typically purchase securities contemplating a three-year holding period. That is consistent with both the typical duration of the fund and our historical turnover rate.
Q: What is your outlook for the mortgage-backed sector for 2003?
A: The 2003 outlook for mortgage-backed securities is for relatively low volatility. The returns from generic mortgage-backed securities are likely to be between 3% and 5% total return, even if there's a 150-basis-point interest rate move in either direction. Whether this type of return will exceed Treasury or corporate returns will depend upon the direction of interest rates.
Should interest rates rise, mortgage-backed securities will be the top performers among fixed-income funds. Should interest rates fall, mortgage-backed securities will probably lag. For certain, we know that early 2003 will continue to be a very high prepayment time period, and we expect our approach should result in significant outperformance for the fund compared to generic mortgage-backed securities
Managers of mortgage funds do have to keep a sharp eye on something called prepayment risk, however. With interest rates at historic lows, returns on mortgage securities can be hurt when homeowners refinance at lower rates or pay off their mortgages sooner than scheduled.
The managers of TCW Galileo Total Return Bond Fund (TGLMX) -- Jeffrey Gundlach, Philip Barach, and Frederick Horton -- focus on investing in securities with less overall prepayment risk. The portfolio gained 9.8% for the 12-month period ended November, while the average mortgage fund rose 6.2%. For the three-year period ended November, TCW Galileo Total Return gained an annualized 10.7%, vs. 7.8% for the peer group. (By comparison, the most famous bond fund, William Gross' gigantic PIMCO Total Return Fund (PTTDX), rose 5.2% for the 12-month period, and 9.3% annually for the last three years.)
Based on TCW Galileo's stellar results and risk profile, Standard&Poor's upgraded its overall ranking of the fund in August, 2002, to 5 STARS from 4. It's worth noting that though the portfolio changed its name from TCW Galileo Total Return Mortgage-Backed Securities Fund in May, 2002, it remains a mortgage fund through and through.
Palash Ghosh of S&P's Fund Advisor recently spoke with Gundlach about investing in the sector and the fund's strategy. Edited excerpts from their conversation follow:
Q: Are you permitted to invest in other types of fixed-income securities? The portfolio appears to be almost entirely composed of mortgage-backed securities.
A: We are permitted to invest certain portions of the fund in fixed-income securities other than mortgages. However, we have never done so and are not contemplating such investments at present.
Q: Why are mortgage-backed securities, which now account for the largest portion of the fixed-income market, the most attractive bond investment now in your opinion? Is it primarily their low credit risk?
A: There can be no disagreement that mortgage-backed securities have been the most attractive bond investment historically, based on statistical analysis of risk and reward. Mortgage-backed securities have displayed much higher Sharpe ratios than Treasuries, corporates, or high-yield bonds over time. The reason for the higher Sharpe ratios is that the mortgage-backed securities sector has delivered returns equal to or greater than the other sectors and has done so with lower volatility.
Looking forward, we can estimate prospective risk/reward outcomes by comparing the yields and durations of the various market sectors using available statistics from index providers. To summarize, this data suggests that the future should resemble the past, with mortgage-backed securities continuing to exhibit superior Sharpe ratios.
The fact that superior risk-adjusted returns are offered by mortgage-backed securities is the primary reason to view them as currently attractive. If this return profile can be achieved with the added comfort of not having to worry about credit losses, so much the better.
Q: Are you completely bearish on corporate bonds right now? If so, why?
A: I'm not completely bearish on corporate bonds, but I'm not completely bullish on them either. The trouble with corporate bonds right now is twofold: First, we remain in an environment of high defaults and persistent downward revaluation of corporate health. This suggests that the risk of "blow-ups" remains high and that corporate bonds continue to be a poor choice as a diversifier for equity exposure in a balanced portfolio. Second, corporates as a sector have a very high duration. This suggests that rising interest rates would cause significant price deterioration in corporate-bond portfolios.
These two considerations put together create a situation where it's difficult to see corporates truly thrive. If interest rates remain low, presumably it will be because the economy remains weak, and therefore credit risk remains high, thereby sustaining a negative default trend. Conversely, if credit health improves overall, it would presumably occur in a strengthening economic environment, which would put upward pressure on interest rates. That would negatively affect corporates due to their long durations.
Q: How would mortgage-backed securities fare in comparison, given a rise in interest rates?
A: No fixed-income investor should expect strong returns on an absolute basis when interest rates rise significantly. However, on a relative basis, one can expect mortgage-backed securities to perform well in such an environment. The reason is that mortgages have the shortest duration of any bond sector, which makes them the least volatile and therefore the least vulnerable to price deterioration as interest rates rise. An analysis of historical results supports this view.
Q: What's your approach to the portfolio relative to the index?
A: We attempt to position ourselves to have less prepayment risk than the generic mortgage-backed securities sector. Our pass-throughs [or mortgage-backed securities] tend to avoid moderate-premium 30-year securities and instead hold adjustable-rate pass-throughs, prepayment penalty pass-throughs, 15-year and 20-year pass-throughs, and discount or current coupon pass-throughs.
Q: Do you typically keep a low exposure to privately issued mortgage-backed securities?
A: We typically invest the great majority of the fund in government or agency-backed securities. The nonagency securities we hold are all AAA-rated. Their rating comes not from a guarantee, but instead from a senior position within a senior/subordinated structure. The exposure to these AAA-rated, nonagency, mortgage-backed securities is currently about 18%, a fairly normal percentage for the fund.
Q: How are you coping with the fact that rates on home mortgages are reaching all-time lows, and how do you deal with refinancings? Is it possible to minimize the risk involved in prepayments?
A: It's true that mortgage interest rates are at multidecade lows and that refinancing is at record highs. This environment exposes mortgages to a heightened reinvestment risk. We cope with this risk by investing in securities that have much less overall prepayment risk than the generic mortgage indexes. It's not at all impossible for mortgage-backed securities funds to deliver positive returns in this environment.
We have relatively low exposure to moderate-premium pass-throughs that comprise a large portion of these indexes. Instead, we favor collateralized mortgage obligation (CMO) securities with lock-outs from prepayments for many months, even if interest rates remain at these levels. We also invest in pass-throughs that have reduced refinancing response compared to standard newly issued 30-year pass-throughs. These would include 15-year mortgages and prepayment-penalty mortgages.
Q: How does the fund's average duration and average yield compare with its benchmark? Do you try to keep these characteristics close to that of the index?
A: Our primary benchmark is the Lehman Aggregate Index. Our secondary benchmark is the Lehman Mortgage Index. We think of our goal as outperforming both the PIMCO Total Return Bond Fund and the Vanguard GNMA Fund (VFIIX) over rolling three-year time frames.
The yield of the fund is typically similar to that of the Lehman Mortgage Index, which is typically similar to that of the Lehman Aggregate Index. The duration of the fund typically lies between those of the Lehman Aggregate and the Lehman mortgage-backed securities indexes. This means the fund's duration is typically less than that of the Lehman Aggregate index and greater than that of the Lehman mortgage-backed securities index.
Consistent with these facts, the fund's beta is less than 1 when compared to the Lehman Aggregate Index, but greater than 1 when compared to the Lehman mortgage-backed securities index. The current duration of the fund is 2.65, just about midway between 3.8 for the Lehman Aggregate and 1.1 for the Lehman mortgage-backed indexes.
Q: The fund had a turnover rate of 24.8% for the 12-month period ended September 30, 2002. What is it typically?
A: Our annual turnover rate is typically about 30%, and has been slightly lower than that over the past 12 months. Our approach is to buy relatively "cheap" securities that provide a yield similar to the generic mortgage sector, but a lesser degree of prepayment risk.
The goal is to structure portfolios to be better equipped to withstand interest rate and prepayment volatility. Achieving this does not require high portfolio turnover. In fact, we typically purchase securities contemplating a three-year holding period. That is consistent with both the typical duration of the fund and our historical turnover rate.
Q: What is your outlook for the mortgage-backed sector for 2003?
A: The 2003 outlook for mortgage-backed securities is for relatively low volatility. The returns from generic mortgage-backed securities are likely to be between 3% and 5% total return, even if there's a 150-basis-point interest rate move in either direction. Whether this type of return will exceed Treasury or corporate returns will depend upon the direction of interest rates.
Should interest rates rise, mortgage-backed securities will be the top performers among fixed-income funds. Should interest rates fall, mortgage-backed securities will probably lag. For certain, we know that early 2003 will continue to be a very high prepayment time period, and we expect our approach should result in significant outperformance for the fund compared to generic mortgage-backed securities
