LOS ANGELES - Only time will tell whether Metropolitan West Asset Management LLC's portfolio managers made a savvy bet on WorldCom Inc.'s bonds.
Each of the 175 portfolios comprising MetWest's three fixed-income strategies held 2% to 3% positions in WorldCom on June 25, the day the Clinton, Miss.-based company announced its bankruptcy filing. WorldCom bonds dropped 80% the next day and currently are worth about 13.5 cents on the dollar. MetWest isn't revealing the total dollar amount of its holdings.
Many institutional clients and consultants are hoping that MetWest's portfolio managers are right. Others may cut their losses by terminating MetWest now, on the advice of their consultants.
MetWest managers are certain the WorldCom bonds will recover to near-par levels after the company emerges from organization under Chapter 11 of the U.S. Bankruptcy Code. In fact, the opportunistic and value-oriented MetWest managers predict that because of the value of WorldCom's hard assets, it will emerge stronger, more flexible and freer of debt - and with few competitors.
As insurance, Mark Unferth, a MetWest senior high-yield portfolio manager, is sitting on WorldCom's creditors' committee.
"We'll live or die by our sword," said Tad Rivelle, chief investment officer. "We believe that WorldCom bonds will keep their intrinsic value, and we stick by our conviction that the economy will recover and that rationality will return, although perhaps with a vengeance."
MetWest's "belt and suspenders" investment philosophy is fundamental, assessing companies on the basis of strong management and an appraisal of hard assets that could be sold to reduce leverage and protect creditors, said Mr. Rivelle. The strategy kept MetWest away from bonds from troubled companies like Tyco International Ltd., Adelphia Corp.and Enron Corp., which lacked sufficient hard assets to protect creditors, he said.
MetWest managed $18.3 billion as of June 30, most of it for institutional clients.
Not a proper decision
"There were people who sold their WorldCom positions on June 26, when the bond was trading at 10 cents to 15 cents on the dollar. But those bondholders who sold WorldCom will recognize in a year that it might have been emotionally satisfying but was not a proper decision," Mr. Unferth said.
In the meantime, MetWest clients are enduring significant pain.
Composites of MetWest's total return, low-duration and intermediate-duration fixed-income separate accounts were rock-bottom: Each ranked in the 10th decile for the second quarter and the year ended June 30, and in the ninth decile for the annualized three years ended June 30, in Pensions & Investments' Performance Evaluation Report. For the total return strategy, the composite return was -0.51% for the second quarter, 3.74% for the year, 6.89% for the three years and 7.63% for the five-year period.
Composite separate account returns for the low-duration and intermediate-duration strategies also placed in the 10th decile among peer managers in PIPER for the second quarter and year ended June 30 and were in the ninth decile for the three years. Low-duration was in the seventh decile for the five years ended June 30; intermediate-duration ranked in the fifth decile.
The Lehman Brothers Aggregate Bond index returned 3.69% for the second quarter, 8.63% for the year, 8.11% for the three years and 7.57% for the five years. And mutual fund versions of the separate account strategies performed even more poorly.
"It's just about as bad as it gets," said Ted Disabato, president of Disabato Associates Inc., Chicago. One of Disabato's clients, which he declined to identify, just terminated MetWest.
"If you think the stock market is bad, talk to a bond manager. This has been a wicked period for bond managers. But we have a difference of opinion with MetWest about whether they can end up anywhere near par with WorldCom bonds," Mr. Disabato said.
Consultant Susan McDermott, a principal at Stratford Advisory Group Inc., Chicago, said she had similar reservations about MetWest's ability to recoup its WorldCom bond losses. "You can't guard against fraud. A lot of bond managers got hit with WorldCom," she said.
But Ms. McDermott said she was more concerned about MetWest's process and would like to see more stringent risk controls in place. When Stratford consultants recently met with MetWest, portfolio managers talked about temporarily reducing concentrations in single securities but, to be opportunistic, wanted to be able to return to higher concentrations once the bond market recovered.
That was not what Stratford consultants wanted to hear, Ms. McDermott said. "I think I would rather have heard, `We made a mistake and this is what we're doing about it,' " she said.
Michael Rosen, principal at Angeles Investment Advisors LLC, Santa Monica, Calif., agreed. Mr. Rosen said he has two serious concerns with MetWest's investment process.
First, the portfolios' level of risk is high because of concentrated investments made in volatile companies in the telecommunications industry, a sector that has been troubled for at least a year. "They were taking a lot of risk in the portfolios. Perhaps they understood the risk, perhaps they didn't. Plan sponsors and consultants probably didn't understand the risk, either. A 2% to 3% position in an issuer during normal times is not so bad. But in these times, it's too big. I think they failed to understand how abnormal this time was...," Mr. Rosen said.
Mr. Rosen said he also is concerned about MetWest's selling discipline. "They said that if they buy something and the price goes up, they'll sell. Great idea. But what they haven't said is what happens when the price goes down. They were not hired to run distressed portfolios. They were hired to manage investment-grade bonds. MetWest is sitting on a portfolio with large losses and isn't liquidating. That's just not acceptable for an institutional investor."
Mr. Rosen said he is not issuing a formal recommendation to terminate MetWest, but he predicted that clients probably will do so. "For those who use MetWest as their sole bond manager, these returns are particularly painful," he added.
John West, a senior consultant at Wurts & Associates Inc., El Segundo, Calif., agreed. "A bond manager is supposed to carry you through bear equity markets. It's doubly penalizing when your bond manager is underperforming when most bond managers were up 8% for the year ended June 30."
Some clients are taking a wait-and-see approach, for now.
Howard J. Bicker, executive director of the $39.5 billion Minnesota State Board of Investment, St. Paul, said trustees will no doubt discuss MetWest's "performance issues" at the September board meeting. "We have to just wait. There's not much else we can do while WorldCom is in bankruptcy." Mr. Bicker did not specify how much MetWest manages for the Minnesota Fund.
Staff and trustees of the $250 million Duluth (Minn.) Teachers' Retirement System and the $8.8 billion State Universities' Retirement System of Illinois, Champaign, also are watching MetWest closely, along with their consultants.
J. Michael Stoffer, executive director of the Duluth fund, said: "Of course we get concerned when a manager has poor short-term performance, but we will keep our long-term view." MetWest manages about $87.5 million for Duluth.
James M. Hacking, executive director of the Illinois Universities' fund, aid the staff met with MetWest personnel in late July about the WorldCom bond holdings in the plan's $77 million core plus account. He said fund officials remain committed to the manager for now.
Another client, SEI Investments, Oaks, Pa., remains loyal to its newest manager, said James F. Smigiel, director of U.S. fixed income for the manager-of-managers firm. On June 26, SEI hired MetWest to manage about $1.2 billion in two core fixed-income mutual funds that total $6 billion. "There is utter credit contagion in the market. It's a very unusual time," Mr. Smigiel said. "But we see a lot of viability in MetWest's process and, in our view, it is their credit analysis that gives them a competitive advantage. Their focus on asset-rich companies and their liquidation analysis is what sets them apart. It helps them avoid the real disasters like Enron," he added.