NEW YORK (Reuters) - The Federal Reserve's move to stimulate the economy by buying mortgage securities is proving to be manna from heaven for three of the biggest players in the bond fund business: Pacific Investment Management Company, DoubleLine Capital and TCW.
The three investment firms all manage mutual funds that loaded up on mortgage-backed securities well before the Fed announced last Thursday that it would start buying $40 billion in government-backed mortgage debt each month until there's a sharp improvement in the job market.
With U.S. Treasury yields at extraordinary low levels, bond investors like TCW, PIMCO and DoubleLine have migrated toward mortgage-backed securities as those securities not only provide higher yields but they perform well when interest rates are stable.
It is TCW's flagship fund that is outperforming the ones managed by PIMCO co-founder Bill Gross and DoubleLine founder Jeffrey Gundlach - the two money managers seen as the reigning kings of the bond investing world.
The $7.4 billion TCW Total Return Bond Fund, which has more than 80 percent of its assets invested in mortgage-backed securities, is up 10.68 percent for the year.
The TCW fund is besting the 8.61 percent year-to-date return for the $272.5 billion PIMCO Total Return Fund - the world's biggest bond fund - and the 7.89 percent return posted by the $32 billion DoubleLine Total Return Bond Fund.
In the week since the Fed's announcement of new round of bond buying, known as quantitative easing, Lipper reports that the TCW fund has gained 0.59 percent, while PIMCO has gained 0.565 percent and DoubleLine 0.53 percent.
Bond industry experts say the funds that may generate the best returns are ones with heavy exposure to so-called "private label" mortgage-backed securities, as opposed to mortgage debt backed by government-sponsored mortgage agencies Fannie Mae and Freddie Mac.
These private label mortgage securities have no government guarantee of principal repayment, which distinguishes them from mortgage securities supported by Fannie Mae and Freddie Mac. The mortgages that back private label securities do not have the support of the government and as a result carry default risk, also called credit risk, a hazard absent in securities backed by the U.S. government.
Examples of private MBS securities include those issued by Wells Fargo, Goldman Sachs and New Century. Some private label securities are backed by prime loans while others are backed by subprime or alt-A loans.
The Fed's move might already have the unintended consequence of driving investors into private mortgage bonds because the central bank's action to buy government agency-backed mortgage debt is seen as driving down yields on bonds issued by Fannie and Freddie more than it will affect yields on mortgages securities that aren't backed by the agencies.
And with the housing market showing signs of recovery, managers say there's less risk for an investor in being more heavily weighted in mortgage-backed debt that isn't issued by Fannie or Freddie.
Government-backed mortgage debt has returned about 2.48 percent through July and currently yields between 1.5 percent to 2.25 percent, according to data provided by Angel Oak Capital, a $900 million investment firm that specializes in bond investing. Meanwhile, non-government-backed mortgage debt has returned 15.45 percent and currently yields between 5.0 percent and 6.5 percent.
Bryan Whalen, a co-manager of the TCW Total Return fund, said the lower rates on agency mortgage securities will eventually "push investor dollars" into the riskier non-agency mortgage securities.
"Over the long-term we still believe in the value of non-agency RMBS (residential mortgage-backed securities) and expect it to be a strong driver of performance," said Whalen, who co-manages the fund with managing director Mitch Flack and Tad Rivelle, the firm's fixed income chief investment officer.
The TCW fund has about 34 percent of its assets in non-government-backed mortgage debt and 47 percent of its assets in government-backed mortgage securities.
"Without a doubt, agency MBS yielding less than 1.5 percent should be avoided and instead, investors should focus on private label distressed MBS," said Tom Sowanick, co-president and chief investment officer at OmniVest Group LLC in Princeton, New Jersey.
FED'S SUGAR BOOST
The Fed is hoping that by purchasing agency-backed mortgage securities, it will push home mortgage rates down even further and provide an extra jolt to the housing market and the U.S. economy. Money managers say the impact of the Fed action on the economy is uncertain but some funds were buying up mortgage debt in advance of the announcement, which had been speculated on for months.
"Just with regards to last Thursday and Friday, it was probably more of an agency MBS story," Whalen said. But he said over the course of the year, "the large majority" of the fund's returns has come from its portfolio of non-government-backed mortgage securities.
The top performing fund since the Fed announcement is the Morgan Stanley Mortgage Securities Trust fund, which has risen 0.62 percent and has about 72 percent exposure to government-backed mortgage securities.
Sheila Huang, the manager of the Morgan Stanley fund, which has about 23.5 percent of its holdings in non-government-backed mortgages, said privately issued debt "may end up being the better performing sector going forward."
Brad Friedlander, the head portfolio manager of the Angel Oak Multi-Strategy Income Fund, said the yields on non-government-backed bonds boast are "still glaringly high." The $275 million fund is up 19.74 percent this year and has nearly 80 percent of its holdings in privately issued mortgage debt.
Friedlander said the Fed's stimulus "is just broadly beneficial to the housing market, and anything that's beneficial to housing typically will be beneficial to non-agencies."