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Domestic Fixed Income | March 2012
Volatility in the core bond markets offers opportunities to collect excess returnsBy Troy Ludgood and Thomas O'Connor, CFA—Portfolio Managers, Wells Fargo Advantage Total Return Bond FundInvestors in the U.S. bond markets may most remember 2011 for its periods of high volatility and some disquieting spikes in credit risk, particularly in the second half of the year. But despite this volatility, the U.S. core bond markets1 performed exceedingly well on the whole, with the Barclays Capital U.S. Aggregate Bond Index returning 7.84% for the year. And more important, for investors focused on security selection and relative-value trading, elevated volatility actually created a favorable environment for generating excess returns. Managers with expertise in performing bottom-up fundamental analysis and the ability to transact quickly on their information found some compelling opportunities to collect additional value. We continue to see similar opportunities for excess returns in 2012. Volatility in corporate bond prices creates trading opportunitiesThe performance of Morgan Stanley bonds in the final months of last year provides an interesting example. We often trade Morgan Stanley based on relative value to its closest peer, Goldman Sachs. Just as fears of a Greek default led to concerns over contagion effects in Italian and French debt and a worsening of the European debt crisis, news reports suggested that Morgan Stanley had $39 billion in outstanding exposure to French banks. The value of Morgan Stanley debt deteriorated quickly, with spreads increasing to more than 600 basis points. The spread between Morgan Stanley and Goldman Sachs bonds expanded from less than 10 basis points to over 170 basis points.But a sober assessment of Morgan Stanley's fundamentals revealed that the company had $39 billion in gross rather than net exposure, justifying a much lower spread level. Consequently, spreads on Morgan Stanley bonds in both absolute and relative terms declined throughout late 2011 and early 2012, with the spread relative to Goldman Sachs returning to August 2011 levels. These scenarios are exactly what diligent bond investors should be looking for during these periods of volatility, in our opinion. We tactically traded our Morgan Stanley position during late 2011 and collected some substantial excess returns. While the specific bond stories may change in 2012, we continue to see the potential for similar situations in the core bond markets in the upcoming quarters.
Variations in mortgage refinancing shift values in mortgage-backed securitiesIn addition to variations in corporate bond spreads, we see a number of current examples that illustrate how headline risk and volatility often present opportunities to generate alpha2in other sectors as well. In particular, we see evidence of this in the agency mortgage-backed securities market due to the diverging behavior of various large banks in refinancing their customers' mortgages. News reports of government programs aimed at helping underwater borrowers refinance into lower interest rates have caused significant uncertainty in mortgage-backed securities because valuations and excess returns are dependent on the market's expectations for prepayment speeds (percentage of mortgages refinanced or paid off ). But a close look into specific mortgage pools shows great variation in banks' ability and willingness to implement these government programs. These variations often result in near-term dislocations in security pricing that can provide excess returns for investors who best understand the fundamentals.
For example, Chart 2 shows the significant difference in refinancing efficiency for two of the largest banks, JPMorgan Chase (Chase) and Bank of America (BofA). For the same level of interest-rate incentive, Chase customers have been refinancing much more quickly than Bank of America's, in part due to Bank of America's apparent decision to allocate resources away from the mortgage business. In volatile markets, we expect disparities such as these to continue to yield tremendous opportunities for investors who can identify specific mortgage pools with the best fundamental characteristics and the most compelling near-term dislocations in security pricing.
Concluding observationsWhile volatility in the core bond markets may seem disquieting at times, it has also provided some compelling opportunities to capture excess returns in recent quarters. We have seen significant near-term dislocations in corporate bond spreads, such as the case of Morgan Stanley and Goldman Sachs bonds in late 2011, as well as dislocations in securitized products, such as the inconsistencies in prepayment speeds across mortgages originated by differing banks. While the specific stories in the core bond markets may change in the upcoming months, the overarching conditions that often result in opportunities to capture excess returns should remain. In our view, investors with the expertise to perform fundamental credit analysis and the ability to transact quickly on their information should continue to find opportunities to collect excess returns in the core bond markets in 2012.Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk and mortgage- and asset-backed securities risk. Consult the fund's prospectus for additional information on these and other risks. Back to Recent Investment Perspectives
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