Can Europe Muddle Through Its Economic Mess?
Suppose the euro zone actually heals itself. Suppose there’s no Lehman-style blow-up. It won’t happen quickly or easily, but eventually, that’s the way events will unfold, in the view of Tad Rivelle, chief investment officer for TCW and Metropolitan West bond funds.
Rivelle has an opportunity to put his money -- about $70 billion worth of it -- where his mouth is. That’s the amount under his purview. Rivelle was a co-founder of the Metropolitan West fund group, which TCW acquired in 2010. Before starting MetWest, Rivelle was with Pimco, now the nation’s biggest bond-fund manager.
Metropolitan West Total Return (symbol MWTRX), which Rivelle has co-managed since its inception in 1997, has a superb record. It returned an annualized 6.9% over the past ten years , putting it in the top 6% of intermediate-term bond funds. (All results are through June 4.) Over the past three years, the fund has beaten Pimco Total Return (PTTRX), the world’s largest mutual fund, by an average of 2.7 percentage points per year. (For Pimco’s more bearish views, U.S. Stocks and Bonds: Best of a Bad Lot?)
It will take European governments “a considerable amount of time” to work things out, Rivelle says. But eventually, the euro zone countries will agree to stand behind member nations’ debts, probably through euro zone bonds, and on some mechanism to transfer wealth from Germany and the other richer members to the poorer countries. In return, Germany will gain more control over the euro zone. Greece, which Rivelle calls “a basket case,” is likely to be the only country to abandon the euro, but probably not until next year.
Rivelle says euro zone members will achieve a grand bargain because it would be a “catastrophe” for the euro to fall apart -- and the continent’s leaders know it. But gains will come slowly. “The worse things get, the more it motivates European politicians to do the right things,” he says.
Rivelle sees Europe’s overall economy contracting by 1% to 2%, not pleasant for the continent’s citizens, but hardly a catastrophic decline. The turmoil will ding the U.S. economy and those of emerging markets. As the dollar strengthens against the euro, U.S. exporters will feel some pain as their products become more expensive for Europeans.
But the situation in the U.S. is okay, Rivelle says. Treasury yields are close to record lows, which helps borrowers, the banking system is much healthier than it was even a year or two ago, consumers have paid down debts, the housing market is scraping bottom and corporations are raking in profits.
Although growth is slowing in many emerging nations, they will remain the world’s fastest-growing economies. And many, led by China, have huge stashes of foreign currency, which they can use to stimulate their economies.
Where to Invest Now
If you agree with Rivelle’s outlook, where should you put your fixed-income money? Start with securities made up of non-government-backed home mortgages. Many of these were Alt-A or subprime when they were issued. (Alt-A borrowers’ credit was better than that of subprime borrowers but not as good as prime borrowers’ credit.) As such, they have been pummeled mercilessly since the housing crisis began around 2007. “There’s so much pessimism priced into them,” Rivelle says. But if a homeowner, even one categorized as subprime, paid his mortgage for five years, the borrower is unlikely to default, Rivelle argues. He expects these mortgages to return 9% to 10% annualized over the next few years. He also likes commercial mortgages.
Also high on Rivelle’s shopping list are high-yield bonds issued by U.S. companies. Defaults are likely to stay low, he says, because businesses are performing so well. His favorite slice of the junk-bond universe is debt with single-B ratings. Yes, the bonds are risky, but on average they yield about 7% -- about 5.5 percentage points higher than yields on ten-year Treasury bonds.
Rivelle finds most investment-grade corporate bonds “unexciting.” But he likes IOUs in two out-of-favor sectors: financials, particularly the big Wall Street banks, and natural gas companies, which have been hit hard by low gas prices. Both groups offer generous yields.
Selected emerging-markets bonds are also among Rivelle’s favorite buys. He likes both dollar-denominated bonds and those denominated in local currencies. And he has a preference for corporate bonds over government debt.
Rivelle thinks U.S. interest rates in the U.S. will rise, though perhaps not for another year or two, so the interest-rate sensitivity of MetWest Total Return’s bonds is relatively low. About 53% of the fund is in home and commercial mortgages, 17% is in investment-grade corporates, 15% is in government bonds, and 6.5% is in junk bonds. Less than 1% is in emerging markets. The fund’s average credit quality is double-B, putting it in junk territory. The fund’s annual expense ratio is 0.63%.
TCW also offers an emerging-markets bond fund, TCW Emerging Markets Income (TGINX), and a mortgage fund, TCW Total Return Bond (TGMNX), but both funds have only had their current managers in place since December 2009, so it’s hard to recommend them. Not so Metropolitan West Total Return, which is a good-looking fund, albeit a bold one.
Steven T. Goldberg is an investment adviser in the Washington, D.C. area.
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