Pimco Total Return managers reverse course set by Bill Gross

Scott Mather and team buying government-backed bonds, boosting mortgage allocation to 30% from 20% before Bond King's exit

Mar 10, 2015 @ 4:21 pm

By Bloomberg News

The new Pimco managers of the world's largest bond fund are embracing the mortgage securities that Bill Gross shunned.

Scott Mather, who replaced Mr. Gross as one of the portfolio managers of the Pimco Total Return Fund, has been buying government-backed bonds, helping boost its total mortgage allocation to 30% on Jan. 31 from 20% in September. Before he left Pacific Investment Management Co. that month, Mr. Gross had been reducing his holdings of MBS, even as agency securities had their best performance last year since 2011.

Pimco Total Return's managers — Mr. Mather, Mark Kiesel and Mihir Worah — are trying to improve performance after investors withdrew more than $100 billion from the fund last year. They're buying agency mortgage securities to bring the fund's allocation more in line with its index even as BlackRock Inc. and Western Asset Management Co. sell the bonds in anticipation of more volatility and prepayments in 2015.

“They're moving more neutral, which means they expect agencies to perform better than what the fund's prior thoughts were,” said Todd Rosenbluth, director of mutual-fund research for S&P Capital IQ in New York.

The Pimco fund, a staple in the 401(k) plans of millions of Americans, has advanced 0.9% this year, beating 92% of peers, according to data compiled by Bloomberg. In 2014, the fund's returns trailed more than half of its peers as well as its benchmark index, the Barclays U.S. Aggregate.

BUYING OPPORTUNITY

Mr. Mather, who early in his career worked as a trader specializing in mortgage bonds at Goldman Sachs Group Inc., said the fund had sold agency MBS in anticipation of lower prices following the Federal Reserve slowing its asset purchases and its impending rate hike.

“It is relatively unusual for us to own as little agency MBS as we have had,” Mr. Mather, 46, who joined Newport Beach, Calif.-based Pimco in 1998, said in an e-mail. “To some extent we have reduced our underweight by buying select agency mortgages.”

While the Pimco fund's allocation to agency mortgage bonds has increased, it still holds fewer of them than the Barclays index. BlackRock and Western Asset Management had held more or about the same amount of the securities than the index last year and have been selling them since the fourth quarter. The Pimco fund has a bigger allocation to mortgage securities that aren't backed by the government than the index.

CLIENT WITHDRAWALS

Agency bonds started to slow down in the fourth quarter and underperformed Treasuries, according to Bank of America Merrill Lynch index data. This year, they've returned 0.22% compared to 0.11% for Treasuries, the data show.

The mortgage allocation of the Pimco fund may also have increased as managers maintained its non-agency bonds while selling securities in other sectors, said Sarah Bush, a senior analyst at research firm Morningstar Inc. Mr. Mather said the fund's non-agency position hasn't changed meaningfully since September.

Pimco Total Return suffered the most client withdrawals in the history of fund management last year as investors pulled a record $105 billion. In 2014, the firm also lost its co-Chief Investment Officer Mohamed El-Erian. Withdrawals from the $125 billion fund slowed to $8.6 billion in February, the lowest in six months.

The Pimco fund trailed the majority of its peers for three of the last four years of Mr. Gross's management. Before then, the bond king had mostly been untouchable while his fund topped peer rankings and assets more than quintupled over the past decade.

Mr. Gross, 70, said he was leaving Pimco on Sept. 26 and joining Janus Capital Group Inc. The executive committee had threatened to oust him following a power struggle with senior executives. Dan Ivascyn, and MBS expert, is now Pimco's group chief investment officer.

“It can't be ignored that this is their opportunity to remake the portfolio in their image,” said Jeff Tjornehoj, an analyst at Denver-based Lipper, a research firm.

Erin Freeman, a spokeswoman at Janus, didn't respond to an e-mail requesting a comment from Mr. Gross.

BLACKROCK SELLS

Mr. Gross was actively buying and selling mortgage securities throughout his time running the fund, including having more than a 50% allocation to the bonds in mid-2009, according to Mr. Tjornehoj.

Other bond funds had bigger allocations to agency MBS last year, and after selling some securities, they're now underweight like Pimco.

At New York-based BlackRock, the world's biggest money manager, the total return fund has been selling the securities since the end of the year, said Bob Miller, who manages the $6 billion fund. It has returned 0.8% this year, ahead of 67% of rivals after posting gains of 6.5% and beating 98% of peers over the past 12 months.

“It's not a long-term move, but we currently think those securities are overpriced and could have more volatility until there's greater clarity from the Federal Reserve on rate increases,” Mr. Miller said.

Western Asset Management, the bond unit of Legg Mason Inc., also sold agency bonds in the fourth quarter, in part because of concerns that more homeowners would prepay their mortgages. The fund now has a lower allocation than the benchmark index.

“The market last year became complacent on prepays,” said Carl Eichstaedt, who manages the $14.2 billion Western Asset Core Plus Bond Fund and the $3.6 billion Western Asset Core Bond Fund. “At some point we have to start to respect prepays again as the real estate market cures and prices stabilize and more people are above water again.”

Government-backed mortgage bonds are sensitive to swings in how fast homeowners refinance or move before their loans' terms are over. That can cause debt trading for more than face value to pay off more quickly at par, and curb interest payments.

BUYING CMBS

The Western funds have been buying commercial mortgage-backed securities, especially those tied to hotels, said Mr. Eichstaedt, who was one of three Western managers awarded fixed-income manager of the year by Morningstar in 2014.

Some managers are being more selective about the kinds of agency mortgage securities they buy. JPMorgan Chase & Co.'s core bond fund, which has about the same exposure to agency bonds as the Barclays Aggregate, has been buying MBS tied to multifamily buildings backed by Fannie Mae, said Doug Swanson, who helps run the $28 billion fund.

Prudential Financial Inc.'s portfolio manager Mike Collins started selling agency MBS in 2009 and replacing them with non-agency ones as well as CMBS and eventually collateralized loan obligations. The $8.5 billion Prudential Total Return Bond Fund has attracted an estimated $4.6 billion in investor money since September, according to Morningstar. It returned 5.3% over the past year, putting it ahead of 94% of rivals.

With lending standards relaxing, home prices appreciating and the labor market improving, agency mortgages aren't poised to perform that well, he said.

“We hold hardly any traditional Fannie-Freddie agency MBS in our portfolio,” Mr. Collins said. “At our size, we can still take advantage of much higher return opportunities.”

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