TCW Asset Management

This TCW Advantage installment highlights ways in which our analysis is integrated across RMBS metrics through benchmark analysis. We review how TCW develops and maintains custom collateral benchmarks that help our portfolio management team spot risk and value that may be overlooked by others in the marketplace.

It has been six years since the Fed zeroed out rates and still we wait for assisted growth to become real growth. Beginning with the recovery summer of 2010, the Fed has proclaimed that cheap money would rocket the economy to escape velocity, launching an organic, self-sustaining economic recovery. Instead, central bank policy has vaulted asset prices into the stratosphere even as wages wait their turn on the launch pad. Low rates have failed to deliver the goodies, but the Fed has its story and is sticking to it.

5 years removed from the depths of the crisis and behind the tailwinds of an incredibly accommodative Federal Reserve, asset prices and of course Non Agency RMBS prices have improved dramatically. When double-digit loss adjusted yields were available most participants in the market did very well if they were able to simply overcome the fear of buying an asset class that was seemingly in freefall. At current prices and significantly lower loss adjusted yields today, however, the margin for error is far lower and many managers without the expertise, infrastructure and experience will underperfor

It isn?t what you earn ? it is what you keep that matters in investing. While systematically underwriting too little risk may mean that you do not earn all that you might, underwriting too much towards the end of a business cycle can be disastrous. With this in mind, it becomes obvious that timing an investment strategy may be the most important single decision an investor needs to get right. But how is one to know where you are in the cycle?

The Non Agency RMBS asset class is still ripe with alpha generating opportunities and attractive loss adjusted yields. Nonetheless, the return prospects have come down versus what we have witnessed over the last few years. Yields are lower and spreads are tighter. However, the fundamental trends continue to improve, which should lead to stronger cash flows and total returns for the non-agency market overall.

With this recovery, prosperity has always been just around the corner. It wasn?t supposed to be this way. True, the massive fiscal and edgy new monetary measures enacted in the wake of the 2008 crisis kept the economy?s heart beating. The Fed deftly executed its role of lender as last resort, and for this we should all be grateful. What has become steadily less clear is why, five years after the crisis, the Fed remains committed to its zero rate policy. Are artificially low rates truly the secret sauce that takes a weak recovery and makes it strong?

The shift in capital flows triggered by former Fed Chairman Ben Bernanke?s tapering remarks in May 2013 set off a cascade of market events that continues to this day. His comments also birthed a cottage industry of emerging market doomsayers, who now predict regularly: 1) the end of growth in emerging markets (EM), given that it was, in their view, all a mirage fueled by carry and leverage; and 2) a wave of defaults of the kind last seen in the 1990s that threaten to bring down not only emerging but developed markets as well.

Non-agency mortgage bond investors look to voluntary prepayment projections as an essential component of assessing future cash flows and returns. Voluntary prepayments are the annualized percentage of the mortgage pool that leaves the pool each month due to refinancing or paying off a mortgage without a loss. Without equity in the home, it is nearly impossible for a non-agency borrower to refinance the mortgage and the sale of a home would generate a loss through a short sale or foreclosure.

Either the markets or the Fed itself will come to accept that financial repression is a box canyon whose only escape is by climbing out through higher rates and wider spreads on risk assets. Staying risk on requires the investor to underwrite the exacerbating risks inherent in an economy that is being given bad signals and is accumulating a menagerie of mispriced assets and bad loans. Yes, you should walk away from a Fed that prints money.

The bond market continues to struggle to find support, with 10-year Treasury yields touching 3%, a sell-off of roughly 140 bps in the last 4 months! While reduced dealer risk capacity and impaired investor loss tolerances are two underlying factors contributing to recent rates volatility, this violent move to higher yields has been primarily led by expectations that the Fed will begin to taper asset purchases in their upcoming meeting on September 18th.

For at least the past five years, the Fed has cast an exceedingly long shadow over the capital markets. For this reason, understanding Fed policy has been central towards proper guidance and direction of investor capital allocations. Since Chairman Bernankes trial ballooning surrounding a potential taper of the Feds QE policy, longer maturity Treasury interest rates have soared over 100 basis points.

Weve just witnessed the dress rehearsal for the end of the Feds Quantitative Easing (QE). Markets that had learned to stop worrying and love the financial repression have been given reasons to fear the interest rate cycle. For five years we have lived with a central bank that has used, or abused, a zero rate policy and QE to effectuate the Great Risk-On trade to cure the ills of the Great Recession.

Markets work. Not because they are perfect, but because they self-correct. Inherent to their functioning is the ability for buyers and sellers, borrowers and lenders, to freely express their predilection to engage in commercial transactions as proxied by the price mechanism. This is all utterly basic. So, why are the capital markets in general, and the credit markets in particular, not to be trusted to operate without the price and quantity guidance of the Federal Reserve? I

Emerging market (EM) local currency bonds broaden the scope for income generation and risk diversification in a global fixed income portfolio. The asset class offers a unique opportunity to access higher income and potential for capital appreciation through a basket comprised of mostly investment grade credits with an average yield spread of 475 basis points over US Treasuries.

As in the case of Europe, the U.S. unemployment situation is likely to get worse in coming months because few moves toward meaningful structural changes in the labor market (e.g., training for the unemployed to improve skills), or fiscal shifts to aid hiring (e.g., targeted employment tax-credits) are likely to be implemented before the November presidential elections. We may have to wait for a reelected President Obama, or President Romney, to move in this direction in 2013.