USAA Intermediate-Term Bond Follows a Contrarian Path

(Editor's note: TheStreet today named 82 mutual funds and exchange traded funds, or ETFs, winners and runners-up in its second annual awards ceremony. A list of the funds and related articles can be found on the awards page.)

NEW YORK ( TheStreet) -- During the market turmoil of 2008, prices of mortgage securities sank hard. That attracted the attention of the contrarian managers of USAA Intermediate-Term Bond ( USIBX). The fund scooped up some deeply depressed securities that carried double-digit yields.

At first the bold move seemed premature. The mortgage securities continued falling, and the fund finished the year in the bottom half of its category, according to Morningstar. Then the unloved securities rallied sharply and USAA topped its average competitor by 16 percentage points in 2009. During the past three years, the fund returned 16.9% annually, outdoing 98% of its peers. The compelling performance enabled USAA to win TheStreet's Best Funds 2012 award in the category of general investment grade bond fund. The runner-up is USAA Income ( USAIX).

Matt Freund

The winning fund is more flexible than many of its competitors. While some peers buy only high-quality bonds, the USAA fund can take bonds of all qualities. "We do not have to hug the index," says portfolio manager Matt Freund. "We can go where we find the bargains."

Freund can shift the credit quality of his holdings as conditions change. During the financial crisis, he had a big stake in AAA-rated securities. At the time, those traded at fire-sale prices and didn't present much risk. These days, many safety-conscious investors have bid up the prices of high-quality securities. That has caused Freund to move away from AAA bonds.

USAA's current portfolio is significantly different from its peers. The average intermediate fund has big stakes in Treasuries and other high-quality issues, keeping 49.5% of assets in AAA-rated securities. In comparison, USAA has only 16.1% in AAA securities. Instead of focusing on the highest-quality issues, USAA has 45.5% of assets in bonds that are rated BBB, the lowest investment-grade rating. The average peer has 19% of assets in BBB bonds. Freund says BBB bonds yield 4%, a nice payout at a time when 10-year Treasuries yield only 2%.

In recent years, the USAA portfolio managers have held a position in high-yield bonds, which are rated below-investment grade. That has helped to boost the fund. After sinking badly in 2008, the low-quality bonds rallied sharply and outdid investment-grade issues by a wide margin in 2009 and 2010. In recent months, high-yield bonds have been climbing as investors gain confidence about the economy and worry less about defaults.

The USAA managers can keep up to 10% of assets in high-yield securities, and the fund now holds a position that is near the maximum. The high-yield bonds currently yield around 7%. Freund figures that the economy will continue improving, which should help to boost prices of high-yield bonds. If the economy sinks into recession, high-yield bonds could drop, but Freund says that the position should pay off eventually.

"We could suffer some poor short-term returns, but the bonds are priced low enough now that they should deliver good long-term returns," he says.

Among Freund's high-quality holdings are commercial mortgage-backed securities. These represent stakes in mortgages on office buildings and other commercial properties. In a typical deal, the mortgages are collected in a pool, and then investors can buy stakes that have different credit qualities. At the top of the heap sit AAA-rated investments that are backed by the most reliable cash flow from the mortgage pool. Lower classes of securities come with more risk and less certain income.

Freund favors the AAA mortgage securities. Those yield up to 4%, a nice spread over Treasuries. He says that the securities provide a rich yield because investors have excessive fears about defaults.

Freund shies away from mortgages that were issued at the height of the real estate boom in 2006 and 2007. In those years, many lenders gave mortgages to shaky borrowers. Instead, Freund prefers loans that were made in 2004, a time when tighter standards prevailed. Because the older mortgages have been in force for eight years now, the mortgages have solid track records.

1. To be eligible for consideration, an open-end mutual fund needed at least a three-year history on Dec. 31, 2011, and still be accepting new assets from retail investors; for exchange traded funds, a one-year history.

2. Half of the rating is based on performance metrics, including total return minus expenses, with a weighting to give long-term performance greater emphasis.

3. The other half of the rating is based upon risk metrics, including standard deviation, size of trough-to-peak (drawdown factor), semi-standard deviation and beta. The lower the risk, the better.

4. Top and runner-up funds and ETFs were selected in a variety of categories (funds and ETF were placed in categories via Lipper data).
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.