Brandywine extends mortgage investment strategy

David Hoffman, managing director at Philadelphia-based Brandywine Global Investment Management, is a fixed-income investor. He discusses how opportunities are evolving post-crisis.

Did you make any asset-allocation mistakes during the past year?

Hoffman: We didn't own the yen. We didn't believe enough in the risk aversion story. We had sold off currencies like the Australian dollar in time, but that was for valuation purposes, not because we were predicting Lehman Brothers was about to go bust.

What's been the biggest government policy blunder?

If the first version of Tarp had been quickly executed, it could have made a real difference. But all the in-fighting with Congress meant the Paulson plan ended up causing the market to bottom instead. Tarp was announced, and then nothing happened; that was a month from hell. And letting Lehman go was a disastrous policy decision. Ben Bernanke says he couldn't save it because he didn't have the policy tools. Only he knows for sure.

What's the challenge for the US government now?

How to transition out of a medicated economy to an un-medicated one. I hope the Democrats don't do another stimulus package, especially one like the first one, which was more about politics than economics.

How is your global fixed-income portfolio positioned?

We are heavy in credit, and we have maintained our exposure to mortgages and high-quality non-agency CMOs.

Why mortgages and CMOs?

The Case-Shiller Index was up for the month of May. Credit rating agencies keep describing the US housing market as if it's down this year by 18%, but in fact it's flattening out. Home prices aren't going to go back up again, but they're stabilising. The affordability level now means almost anybody can buy a home. Maybe not in the same neighbourhood, maybe not if you don't have a job -- but there are now 26 million more households with the income to afford a mid-priced home than there were in 2006.

What portion of the portfolio is allocated to mortgages?

Only 13%, but that's been the strongest performer so far this year. This year we have begun a new mortgage strategy. It's now or never, because in six months this story will be over. The focus is on fixed-rated, senior tranche securities that we believe will mature at much higher prices than what we've bought them for.

What other exposures do you have?

We have a bigger exposure to corporate bonds, which have also done well. We like commodity-based currencies, which are strong. Currency has accounted for 60% of our out-performance against the benchmark in 2009.

Your take on the yen?

It should weaken. It's one of the few currencies not to have returned to pre-Lehman levels, unlike the Aussie dollar or the Brazilian real. Japanese corporate earnings have been poor and the yen is too strong for a world of deleveraging and slow economic growth.

What's your weighting for the US dollar?

We're neutral, although we like US credit. Our new overweight is the British pound, which we hadn't held for two years. When it fell below $1.50, we started to build a position.

What attracts you to sterling other than valuation against the dollar?

The ability for the UK to transmit monetary policy is stronger than in the US. The UK housing market was way overvalued, arguably more overvalued than America's. It had a sharp fall, but then it hit bottom. Because people in Britain are on floating mortgage rates, their rates are now extremely low, which allows individuals there to repair their finances more quickly than people in America. It's similar in Australia, where consumers can heal faster. The US is stuck.

What's the reason for the inertia among American households?

30-year fixed mortgages are like a religion in America. If the US switched to floating-rate mortgages, it would make Fed policy more powerful. But the Fed cuts interest rates only to see long-term mortgage rates remain high. If you hold a 30-year fixed mortgage, the rate you're paying is sticky.

Are you worried about the return of high inflation?

It's not a concern for now. There's excess capacity around the world. Everyone's deleveraging, and savings rates are rising. Later on, the fear of inflation is going to depend on how policy is implemented. But all this talk about how the Fed is going to exit quantitative easing is a good thing. The fact that people are aware of the danger of inflation means there's less risk that it will in fact return.

Do you own high yield?

We didn't buy high yield during this cycle. The economy is still too weak. It's not going to be like 2001 and 2002, in which a downturn was followed by a five-year expansion. This will be trickier.

Credit spreads have come in. Time to sell?

Spreads aren't going to return to 2005-2006 levels, so the narrowing won't be as dramatic as when spreads widened. As spreads narrow over the next 12-18 months, we'll be getting out of credit. We buy credit cheap and sell when spreads get close to normal, instead of trying to squeeze the last year out of the trade.

What do you do with the profits from selling credit?

Probably buy equities.

What about emerging-market debt?

EMD makes up about 15% of our strategy. Over the next decade, we'll put even more emphasis on this area, because of the higher yield and the chance for currencies to appreciate.

Do you buy US dollar-denominated bonds or local currencies?

In EMD, all of our positions are in local currencies.

Is this a good time to be a bond fund manager?

Yep. Nominal GDP growth is low, long-term interest rates are down around 4-5%, and corporate bonds offer high yields. In other words, debt is not cheap, relative to growth. And we own debt. These conditions should allow for capital gains.