Bond funds may have a reputation for being boring, but anybody who attended Morningstar's annual mutual fund conference in Chicago last week might have the impression that the fixed-income market is the most dangerous part of the U.S. financial system right now.
Both the opening and closing sessions featured tough-talking bond fund managers who pulled no punches about the state of the subprime mortgage market and about who was to blame for the mess.
"It's an unmitigated disaster," Jeffrey Gundlach, chief investment officer at TCW Group, said during the conference's opening address. "And it's only going to get worse."
Gundlach said that he expects to see more delinquencies in loans made to borrowers with poor credit histories and that the subprime mortgage market's woes would lead the Federal Reserve to cut interest rates.
Robert Rodriquez, chief executive officer of First Pacific Advisors, was even more blunt. "We haven't seen much of a problem in the subprime area [but only] because the pricing is a fraud; the ratings are bullshit," said the two-time recipient of Morningstar's Fund Manager of the Year.
"I don't buy these prices, but as long as someone can provide capital to keep the finger in the dike, the charade will go on."
Rodriguez concurs with Gundlach that rising subprime mortgage delinquencies are a problem not just for hedge funds but also for major banks and other financial institutions.
"It is estimated that U.S. banks have invested 10% of their assets in collateralized debt obligations," he said. "And 40% of the CDOs are in subprime mortgages. I'm trying to get details on the components and I can't get any. This is setting up the next catastrophe."?
Rodriguez co-manages the FPA New Income fund (FPNIZ), which gained 4.8% last year and is up 2.13% year to date. It also carries a two-star rating from Morningstar.
Rodriguez anticipates a huge drop in the prices of both long-term and high-yield debt and avoids both in his portfolio; as a result, it currently has about 41% of assets in cash. This cautious approach may temper gains, but it also reduces volatility: The fund hasn't suffered a calendar-year loss since Rodriquez took charge in 1984, according to Morningstar.
Stephen Walsh, the deputy chief investment officer for Western Asset Management, voiced similar concerns. "There's been a complacency among investors," he said. "I read that 50% of the (subprime mortgage) loans were low- or no-documentation loans, just state your income without any proof."
Walsh said he didn't understand how anyone could analyze the risk in holding loans when borrowers have little or no equity in the property and there is no way to verify their ability to make payments. However, he said he stayed away from these securities not because of a "doomsday scenario" but rather because of a lack of faith in the analysis.
"How do you make an assumption on a loan that is undocumented?," Walsh said, referring to the lack of documentation of a borrower's employment or income for many subprime loans.
