Thomas Atteberry’s approach to running the FPA New Income Fund is simple. “We always seek to produce a positive annual return,” he says. Atteberry joined Los Angeles-based First Pacific Advisors’ bond team in 1997. Meanwhile, the fund has not had a down year since its current strategy was implemented in 1984.
In order to achieve the lofty goal of hedge fund managers – if not quite on that scale – Atteberry, who officially became co-portfolio manager of the New Income Fund, alongside FPA’s senior partner and CEO, Robert Rodriguez, a year and a half ago, splits the fund in two. About three-quarters of its $1.7 billion is invested in bonds rated double-A or higher, with the balance in names rated single-A and lower.
The bifurcated strategy is, in fact, two strategies. For the high-quality bonds, “macroeconomic policy drives the price,” Atteberry says, particularly the Federal Reserve’s interest rate moves. For the junk side, Atteberry employs the stock picking skills he learned as chief investment officer of Joplin, Mo.’s Mercantile Bank in the 1980s. “Senior, unsecured high-yield bonds are just like equities,” he says. “Analyze it like an equity, make an investment like an equity.”
That’s especially important in the current interest rate environment. With the Fed funds rate rising since June 2004, Atteberry and Rodriguez have relied on the single-A and lower portion of their portfolio to continue their positive returns streak. Indeed, a year earlier, Atteberry says, FPA decided “there is no value in high-quality bonds, and we are not going to buy any of them.” Instead, it’s relying on its approximately 5% high-yield position, as well as interest-only mortgage securities, to produce its returns. In addition, the average duration of the portfolio has almost doubled during 2006, and Atteberry says it will continue to rise.
The fund beat both the Lehman Brothers Aggregate Index and its category by 420 and 470 basis points, respectively, in 1999, then trailed by 230 bps and 50 bps the following year, outperforming both by 390 bps and 460 bps in 2001. The pattern has continued, with the index and category average winning in 2002 by 570 bps and 370 bps, respectively, followed by the fund winning in 20003 by 420 bps and 310 bps. In 2004 and 2005, the fund trailed both, but this year, it has returned 180 bps – good enough to be in the top 1% of intermediate-term bond funds and besting the index and the category average, both of which are in negative territory for 2006.
The strategy produces some wild swings in relative performance: in February, the fund was among the worst performers in its category, in the lowest decile. In March, it was in the top decile. All the while, the strategy has met its baseline goal every year since it was implemented. During that time, it has topped the indices – both the Lehman Aggregate and the Lehman Brothers Government/Credit Bond Index, officially its benchmark – on an annualized basis, beating the former by 48 bps over 20 years, and the latter by 53 bps. And after a lengthy period of losing to the indices on a trailing basis – it has lower returns over 10 and five years annualized – it has experienced something of a return to form over the past three years, enjoying a place among the top 3% of funds in its category over the past three years, one year and year-to-date.
With interest rates now at 5%, and possibly flattening, Atteberry believes that there may be some value returning to the bond market, but he’s not particularly bullish. “If the economy slows, I could see Treasuries” – which make up about 45% of his portfolio – “falling,” he says. And he has “some fear” with regard to real estate prices, this year selling several MBS that began to exhibit an unusual number of delinquencies. But he hasn’t entirely soured on mortgages, especially with cash yields continuing to fall. “In February, we decided we needed to start taking money away from cash and putting it to work somewhere.” One of those places was 30-year pass-through mortgages on single-family purchases; Atteberry put 6.5% of his portfolio in such bonds. He also sold a quarter of his Treasury inflation protected securities to buy three-year agency mortgage securities.
In the meantime, Atteberry and his fellow partners are mulling the future of First Pacific Advisors. The firm’s management holds an option to acquire the business from Old Mutual, the successor to United Asset Management, which bought FPA in 1991.