The Breakdown

Explaining Southern California's economy

Bond kings chase returns in a low-interest-rate world

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51618 full

Heather Perlberg and Pierre Paulden at Bloomberg have a good piece Wednesday about what I call Southern California's "bond triangle" - and its investment managers' relentless quest for returns when interest rates are at historic lows. 

The major players in the story are PIMCO, the nearly $2 trillion fixed-income colossus based in Newport Beach; TCW, with $135 billion in assets under management and in the process of being taken over by the Carlyle Group, a big private-equity firm; and DoubleLine Capital, run by former TCW trader Jeff Gundlach and one of the fastest-growing financing startups in history, with more than $50 amassed in assets in three years. ( TCW and DoubleLine are based in L.A.)

Here's Perlberg and Paulden on how these firms' investment in a risky category of debt has paid off big time:

Non-agency bonds backed by subprime mortgages issued before the housing market collapsed in 2007 beat most fixed-income assets in 2012, with returns averaging 41 percent, Barclays Plc (BARC) index data show.

An index tied to bonds created in the second half of 2006 that were issued with AAA ratings rose about 47 percent last year to 50.4 cents on the dollar, according to London-based administrator Markit Group Ltd.

That compares with a gain of about 16 percent for high-yield, high-risk company debt and a 2.6 percent return for mortgage bonds guaranteed by government agencies including Fannie Mae and Freddie Mac, Bank of America Merrill Lynch index data show.

So mortgage debt the goverment doesn't back up — that's why it's called "non-agency" or sometime "private label" — has generated returns that more than compensated for the risk investors had to take on. When you beat corporate junk bonds — "high-yield, high-risk company debt" — by 25 percent, you're doing something.

Collectively, PIMCO, TCW, and DoubleLine have played the high-risk part of the housing recovery very well. And there's still some room to run, although the outsized double-digit gains on 2012 could give way to more modest returns that bump up against 10 percent. That still looks pretty attractive. And until the the market for mortgage-backed securities (MBS) not insured by the government picks up — it's been moribund since the financial crisis — there will continue to be reliable demand for private-label MBS.

Underlying all this is a genuine, if moderate, housing market recovery. If you think it's real, that removes some of the risk rrom investing in riskier mortgage-backed assets. If you think it isn't, then new private-label issues may not materialize and returns could fall back to earth.

But for the time being, the bond kings of Southern California are doing a pretty good job of making the most of a market that's defined risk for the past five years.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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