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Friday, Jun 2, 2023

Bond Crazy

Quick – name some major Southern California bond firms not named Pimco.


The Newport Beach bond giant Pimco is perhaps the most well-known fixed-income investment firm in the world, its name familiar to even the least bond-savvy. And its outsized reputation has overshadowed the fact that Los Angeles County might just be the bond capital of the United States.

Though not considered a major financial center, Los Angeles is home to a thriving community of fixed-income investment firms, including some of the world’s largest and most influential bond managers.

“They are the crème de la crème,” said Cynthia Steer, chief strategist at Rogerscasey, an investment consultant in Darien, Conn.

Western Asset Management in Pasadena and Capital Research and Management in downtown Los Angeles – each with 12-figure fixed-income investment portfolios and employees across the globe – are two of the largest bond fund managers in the world.

In fact, 15 firms headquartered in the county manage multibillion-dollar bond portfolios, while a number of major nonlocal firms, such as Dimensional Fund Advisors, have large L.A. operations.

And it’s not just about size: TCW Group Inc. in downtown Los Angeles and Western Asset also manage some of the best performing bond funds in the United States.

Meanwhile, local firms are producing many of the industry’s biggest stars. Jeffrey Gundlach, Robert Rodriguez and Tad Rivelle are among the most renowned names in the bond world. Each of the Angelenos has taken home the coveted Fixed Income Manager of the Year award from research firm Morningstar Inc. within the past five years. In fact, seven of the last 10 awards have gone to Southern California managers.

Surprising? Maybe, but it points out the low-key nature of the bond industry. Many L.A. firms prefer to do their business out of the spotlight. Capital Research, the investment behemoth owned by Capital Group Cos., is notorious for its unwillingness to make executives and managers available to the press. Capital Group’s top executive, James Rothenberg, recently gave his first media interview in five years for an April article in Bloomberg Markets magazine but did not speak with the Business Journal.

They hardly need the publicity. Traditionally seen as a conservative alternative to stocks, bonds have been gaining favor among investors since the crackup of the equities markets following the housing bust. Over the past year and a half in particular, wary investors have rushed to bonds as a safe haven from the volatility of equities.

In 2009, fixed-income funds benefited from record inflows of $375 billion, according to the Investment Company Institute. Indeed, the inflow has been so strong that some experts are warning about a possible bubble forming in the bond market that could burst if the government raises interest rates.

“It’s been a stampede,” said Marilyn Cohen, author of “The Bond Bible” and founder of Envision Capital Management in Brentwood. “We have never seen the continuation of such a flow into bond funds. (Individual investors) have very little confidence in the equity market and there’s zero percent yields in money markets and close to zero in the CDs.”

For now, bond investors have been rewarded. Through the first five months of the year, the Barclays Capital Aggregate Bond Index, a widely watched industry benchmark, was up 2 percent. The S&P 500, by comparison, was down 2.4 percent.

Los Angeles is not the only place with large bond managers. New York, Boston, Baltimore and other cities are home to influential fixed-income firms, yet few if any cities can claim such a heavy concentration of the nation’s largest bond firms.

Deep connections

More than simply a collection of firms, L.A.’s bond investment community is a web of intricately connected players. Perhaps no instance displays that more clearly than the dramatic events of late 2009.

In early December, Gundlach, a one-time rock-and-roll drummer who had become one of the most renowned bond fund managers in the country, was fired by TCW, where he had managed 70 percent of the firm’s $100 billion in assets. The firm alleged that Gundlach threatened to quit, taking his team and company secrets with him; the fund manager said he simply inquired about purchasing the firm from parent Société Générale.

Almost immediately, Gundlach launched his own firm, DoubleLine Capital, which has since introduced several mutual funds. To get the firm off the ground, Gundlach turned to Oaktree Capital Management, a downtown L.A. firm that was also founded by former TCW refugees. Oaktree, L.A.’s fifth largest bond investor with more than $30 billion in fixed-income assets under management, has taken a minority stake in the new firm.

To fill the hole left by the departure of Gundlach and his team, TCW acquired Metropolitan West Asset Management, a respected local bond firm with $30 billion under management. The blockbuster deal was quickly arranged, but the integration was fairly smooth, said Rivelle, a founding partner of MetWest who is now the chief investment officer of high-grade fixed income for TCW.

“It’s pretty much business as usual,” he said. “Time will tell if the TCW business has suffered any long-term drawbacks from this, but I think that the indications are for the most part that most of this has faded into history.”

The four firms are not the only local ones with deep ties.

Beach Point Capital in Santa Monica, for instance, was formed by several managers who split off from Post Advisory Group, a fixed-income investment firm with more than $9 billion under management.

“There is tremendous concentration (of bond firms) out there,” said Russel Kinnel, director of mutual fund research in Morningstar’s Chicago offices.

But why exactly is there such a concentration in Los Angeles?

Opinions are divided. Some believe local managers benefit from being far from the echo chamber of Wall Street. Others say that the West Coast is well-positioned to capitalize on the growth of the Asian markets.

Howard Marks, Oaktree’s chairman, has a different theory. He points to a decision in 1978 by financier Michael Milken to relocate the high-yield bond operations of Wall Street giant Drexel Burnham Lambert to Los Angeles. That move was a major draw for many of the industry’s top minds, said Marks, one of Milken’s first clients.

“Mike Milken attracted some people here and some of the people who came out of Drexel went into that business,” said Marks.

But even he has to admit that there may not be any good reason that Los Angeles has emerged as a major bond investment center: “Maybe it’s chance. I don’t know.”

Market evolution

Over the past 10 years, the bond market has gone through an unprecedented evolution.

An explosion in the popularity of mortgage-backed securities has helped more than double the size of the U.S. bond market. At the end of 2009, the U.S. bond market had a value of nearly $35 trillion, according to the Securities Industry and Financial Markets Association, an industry trade group.

Bonds are issued by the federal government, corporations, and state and local government agencies, among other entities, to fund a variety of public and private expenditures. The securities, which pay interest at regular intervals and full principal at the maturity date, are known as safe, conservative investments. It’s a reputation largely derived from Treasuries, low-interest rate bonds backed by the full faith and credit of the federal government.

Unlike individual bonds, which pay full principal at the maturity date, bond funds typically trade the securities before they reach maturity, lending uncertainty to yields. However, yield variations are small and generally measured in basis points – hundredths of a percentage point.

But fixed-income investments are far from risk-free. The rise of mortgage-backed securities and related derivatives, the increasing popularity of distressed debt and the potential for municipal defaults raise the level of risk.

What’s more, bonds are vulnerable to the threat of rising interest rates. Bond prices and yields have an inverse relationship. As a result, if interest rates go up, the value of bonds trading on the secondary market will fall, lowering fund returns and making long-term bonds risky for traders.

“Bonds don’t mean the same thing to everyone,” said Rogerscasey’s Steer. “Relative to the investment landscape, they’re probably the least understood and most complex investments you’re going to make – but the most necessary.”

At least for now, though, a number of local funds have made huge gains.

MetWest’s short-term bond fund, Strategic Income, earned a 12-month total return of 39.7 percent as of June 1, the fourth best performance of 5,822 bond funds tracked by Morningstar. The high-yield fund at CNI Charter, the mutual fund arm of L.A.’s City National Corp., was the 28th best performer, pulling in 29.2 percent during the period.

Even those in the mortgage bond segment have done well. Mortgage-related bonds, with a total value of $9.2 trillion, accounted for more than one-quarter of all outstanding bond debt, the largest single category. While investors have suffered tremendous losses in mortgage-backed securities since the housing bust, some of the savviest investors have managed to make it through the storm relatively unscathed, and are even finding opportunities to pick up bonds at great values.

TCW’s Total Return Bond Fund, which invests primarily in mortgage-backed securities, is one of the top performing bond funds over the past five years, according to Morningstar. With annualized returns of 7.55 percent, it had the top returns among local funds and was the 25th best performer overall out of more than 4,500 funds in the time span.

TCW and most other firms invest in a variety of bond types, including Treasuries, municipal bonds and corporate debt.

Nearly one-fifth of Western Assets’ investment portfolio, for instance, is in investment-grade bonds – those with the lowest default risk and high grades from the credit rating agencies – while nearly as much is in Treasuries. Less than 9 percent is in mortgage-backed securities.

Oaktree, which has $76 billion under management, favors high-yield and distressed corporate debt, which accounts for more than two-thirds of the total investment portfolio. Marks said high-yield debt helped lead the firm to its best returns in history in 2009.

“In general, everything turned out better than (expected),” he said.

Strong returns

Despite the strong returns, no Los Angeles County firm receives as much attention in the press or among the investment public as Pimco.

Founded in 1971, the firm has grown into an industry powerhouse, managing more than $1 trillion. Bill Gross, who co-founded the firm, has helped Pimco become one of the top performing mutual fund firms, and for his achievements he was recently named Fixed Income Manager of the Decade by Morningstar.

But the firm’s clout is due to more than its performance, Cohen said. Pimco’s willingness to publicize itself helps bring in business.

“Not only do you have to be smart and have decent performance, but you have to have name recognition,” she said. “Their name is out in front of the investment public all the time. Trust Co. of the West isn’t. FPA isn’t. (Capital Research) isn’t. I just don’t understand why the other biggies don’t spend as much intellectual and good, old regular capital on marketing, but they don’t.”

Chuck Freadhoff, a spokesman for Capital Group, said the reason is simple: “We feel that our investment professionals should be managing money and not taking time away from their core jobs to promote the funds.”

This much is true, too. For the past decade or so, and especially over the last few years, bond firms haven’t really needed to promote their services.

But now many experts believe the record inflows may not be such a good thing. They are increasingly warning about the possibility that a bubble may be forming as unsophisticated money moves into bond funds – money that could flee at the first sign of trouble.

“Any time you see a single asset class so overwhelmed by cash – we saw that at the beginning of this decade in tech stocks – eventually the luster will wear off, or some type of event will happen, and then it will be a mass exodus out,” Cohen said. “It cannot have a happy ending.”

A number of industry observers expect the federal government to raise interest rates as early as late 2010, which would lower the yields on long-term fixed-income investments and could spook investors. If investors were to pull their money from funds, it could affect others in the fund by forcing portfolio managers to readjust the holdings and sell certain assets in order to have sufficient cash for investor redemptions. Some funds could even be forced to close.

That’s why Cohen believes investors should buy short-term individual bonds they can hold to maturity and thus not have to face the issue of fund redemptions.

Not everyone is so worried, though.

Paul Curley, a research analyst with mutual fund tracking firm Financial Research Corp. in Boston, said even if there is a bubble in bond funds, the economic rebound will be slow, preventing a rapid rise in interest rates that could scare investors away from bond funds and any exodus likely would be slow.

“Interest rates haven’t been going up as quickly as people thought,” he said.

TCW’s Rivelle questions whether there is even a bubble to begin with, arguing that bond funds may simply be on the receiving end of money that had gone into hedge funds while they were hot last decade.

“More likely, we’re simply seeing a renormalization or rebalancing of flows into fixed income,” he said. “The thesis that there’s a bubble in Treasuries is not proven at this point.”

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