Homestead’s Kern bets on risky BP bonds to beat rivals

BOSTON (Reuters) – Douglas Kern, manager of the Homestead Short-Term Bond Fund, had seen all kinds of market meltdowns and panics in his 35 years in the bond business, but nothing like the credit crisis of 2008.

The housing crash and ensuing Great Recession sank Kern’s fund to its first losing year, dropping 3.52 percent. Competitors lost more, however, suffering an average loss of 4.23 percent, particularly those that had bought initially highly rated securities backed by subprime mortgages before the crisis struck.

As the crisis deepened, Kern watched as some bonds lost two-thirds of their value, and he began sorting through the wreckage to see which were worth snapping up.

“I saw bargains I didn’t think I’d ever see in my career,” he said. “I put the pedal to the metal.”

He avoided the temptation to buy the hardest-hit mortgage-backed securities and instead loaded up on other asset-backed paper supported by auto, credit card and student loans.

The strategy paid off as the crisis abated and he was holding the bargain-priced securities that were now paying yields above 15 percent.

In the year that followed the fund posted a return of 16.4 percent, a stunning gain for the short-term bond category, and more than 7 percentage points above the average return of similar funds.

Kern’s $326 million fund and others run under the Homestead family were started by the National Rural Electric Cooperative Association for its members but are now open to the general public.

His fund hit a gusher by drilling into BP debt paper after the Deepwater Horizon drilling platform exploded. As investors dumped BP securities and bond yields soared he put almost 3 percent of the fund’s assets into BP debt — a move that ultimately paid off.

“Frankly, you’re not going to get any bargains buying the stuff everyone wants to own,” he said.

While the post 2008 years were exceptional, the fund also qualified for a Lipper award because it also showed steady gains over a longer period. The fund gained an average of 5.89 percent annually for the three years ended December 31, 2010, better than the category average of 3.07 percent a year, according to Lipper data.

Lately, he found bargains in the neglected municipal market, where Kern got his start as an analyst in 1975.

Almost 18 percent of the fund is currently invested in munis at the high end of the fund’s permitted allocation and up from 11 percent at the end of 2009. Most recently, he has been buying short-term taxable issues, a combination of private activity bonds backed by corporations and Build America bonds, he said.

Concerns about a wave of defaults in the muni market are overblown, Kern said. “There’s a lot of hysteria,” he said. “I’m comfortable with the space.”

Looking ahead, Kern expects the Federal Reserve will have to start increasing interest rates early next year. He expects only “modest moves” in 2012. Since the credit crisis, the target Fed funds rate has been set at a range of 0 to 0.25 percent, its lowest ever.

“We have a budding inflation problem and the need for zero interest rates is long past,” Kern said. Kern has about one-quarter of his fund in floating rate instruments that will benefit from rate hikes, including bonds backed by student loans.

(Reporting by Aaron Pressman; Editing by Walden Siew)

Homestead’s Kern bets on risky BP bonds to beat rivals