To fight low yields, fund chooses spread product

By Ellen Freilich

NEW YORK, Oct 12 (BestGrowthStock) – Overweighting spread product
and significantly underweighting government sectors like
Treasuries and agencies is the strategy Prudential Total Return
Bond Fund has taken to boost returns in an era of low yields.

That means the fund looks not only at investment-grade
corporate debt, but also for diamonds in the rough in
asset-backed and commercial mortgage-backed securities, as well
as senior secured loans, sectors some investors avoid.

“The Fed’s purchases have supported Treasuries so mortgage
and agency yields are really low,” said Michael Collins, senior
investment manager and a senior portfolio manager for
Prudential’s Total Return Bond Fund, a mutual fund investing
just over $700 million of Prudential Fixed Income’s $254
billion assets under management.

As of Aug. 31, 2010, all of the fund’s classes had
outperformed the 8.23 percent Lipper Average for year-to-date
performance.

Because 10-year Treasury notes now yield just under 2.40
percent, only about 15 percent of the Total Return Fund’s
portfolio is in the government sector (Treasuries, mortgages,
agencies), “a fairly dramatic underweighting,” he said.

In contrast, the fund is overweight several spread sectors,
including investment grade and high-yield corporate bonds.

“Year-to-date the high-yield default rate is almost zero
for big corporates, down from 15 percent last year,” Collins
said. “We’ve been adding high-yield on the premise that the
default rate will be very low for the near term while the
spreads remain wider than their historical average.”

Recent regulatory reform in the financial sector favors big
money center banks, insurance firms and brokers, Collins said.

“We believe the regulatory reform is generally a positive
from a credit quality standpoint,” he said. “It means
less-risky business models and better capitalized entities.”

The Total Return Fund uses credit research to find value in
the BBB space, Collins said.

For better relative and absolute return opportunities, the
Total Return Fund overweights high-yield corporates and senior
secured bank loans. Those two sectors combined comprise about a
15 percent overweighting.

Structured products — commercial mortgage- and
asset-backed securities — make up nearly a third of the fund’s
portfolio.

“Though these have rallied significantly this year and last
year they still offer quite a bit of value,” Collins said.

Within commercial MBS, the fund favors the senior-most
tranches that could withstand credit losses in the underlying
commercial mortgages, he said.

“Based on the research we do to drill down on the structure
of these securities, we see the risk as very limited,” Collins
said. “And they still offer a spread of LIBOR plus 2.25
percent.”

Some subprime or home equity securities have come back, but
still trade “at significant discounts to what we think is their
fundamental value,” he said.

“We generally favor securities based on loans originated in
2003, 2004 and 2005, in contrast to those made later when the
underwriting was abysmal,” he added.

Collins admitted the asset- and commercial-mortgage-backed
securities markets are not yet out of the woods.

“They could languish for years, so some investors still
struggle with the fundamental value of the underlying
collateral in these products. But even if we assume price
declines of another 10 to 20 percent, the securities we’re
buying still will offer value,” he said.

While there are fewer buyers of asset-backed and commercial
mortgage-backed securities, there are also few issuers.

“They’re still available in the secondary universe and
people tend to buy and hold them,” Collins said. “The spreads
available today won’t be available in a year or two.”

Senior secured loans are another sector of interest.

“They offer floating rates, typically are secured by
company assets and are performing really well,” he said.

One risk in this asset class is that the loans are getting
refinanced at a pretty significant rate, Collins said.

“That’s to the issuers’ advantage because it lowers their
interest rate, but it’s also good for us because when they
refinance we get a par payment on something that’s trading
below par,” he said. “So you get price appreciation.”

The Fund’s Class A shares have a three-star rating from
Morningstar. Its Class C and R shares have a four-star rating,
and its Class Z shares have a five-star Morningstar rating.
(Editing by Dan Grebler)

To fight low yields, fund chooses spread product