Bearish on bonds

NEW YORK (Fortune) -- When other mutual funds were flourishing, First Pacific Advisers' New Income, a conservative fund that invests in different types of bonds, struggled: It returned just 2.6% in 2004 and 1.6% in 2005, lagging the average intermediate-term bond fund, and suffered net redemptions of $432 million between May 2005 and May 2006. Since the credit market meltdown, however, the fund has thrived, returning 4.3% last year -- a full 9 percentage points more than its average peer.

Does manager Tom Atteberry feel vindicated? "We don't manage to an index," he says, shrugging off the reversal of fates. "We manage to a process that tells us, at the end of the year, we need to have a positive return."

Since First Pacific Advisers bought the New Income fund from Transamerica in 1984, it has never posted an annual loss. Atteberry co-manages the fund with FPA president Bob Rodriguez, who was widely lauded last year for predicting the credit crisis. Rodriguez recently announced that he's stepping down at the beginning of 2010 to take a sabbatical. He will pass the reins of FPA New Income (FPNIX) to Atteberry, who has worked alongside him for 12 years and officially co-managed the fund since 2004.

FPA's investors will experience few changes after the hand-over. Atteberry, like Rodriguez, is a cautious steward with a gloomy view of the economy right now. "There's a long road to recovery," he says. "One of my analysts says it's like a caterpillar -- it's going up and down."

For that reason, Atteberry is keeping 24% of the fund's assets in cash, just 2% in corporate bonds, and less than 1% in high-yield bonds. While many fixed-income investors have gone back into junk bonds since their priced tanked last winter, driving their yields, which move in an opposite direction, down ten percentage points since then, Atteberry thinks the rebound won't last. "It isn't sustainable -- they're going to roll over again," he says, pointing out that 42% of the issuers of high-yield bonds have highly leveraged balance sheets -- much more than in previous years.

Atteberry's fund hasn't always avoided high yield bonds. Back in 2002, he says, 25% of its assets were invested in them. Now, he is cherry-picking a few esoteric issues. For example, he recently bought senior debt from Michaels, the DIY arts and crafts retailer, that matures in October 2014 and yields about 11%. He also owns Enhanced Equipment Trust Certificates from Delta Air Lines (DAL, Fortune 500). These bonds, which mature in 2012, are backed by actual aircraft; he thinks the value of the collateral limits the bonds' downside. "We're finding trading opportunities in little, one-off places," he says.

Atteberry keeps the bulk of the fund's assets in agency bonds and agency mortgage-backed securities. He likes agency bonds called step-up notes, which are issues that periodically increase their coupons or the interest rates they pay investors each year.

"They help protect principal in a rising interest rate environment," he says. When interest rates go up, most bonds' values go down, because their coupons are worth less on a relative basis. But step-up bonds' rising rates can offset the difference. If their coupons rise higher than interest rates, their issuers typically call them back, returning principal to the investor.

FPA New Income scrupulously avoided subprime-related securities going into the recession (in past letters to shareholders, Rodriguez and Atteberry railed against their evils). Now, Atteberry is buying mortgage-backed securities from government agencies with a discerning eye. "We ask, what kind of borrower are we willing to deal with?" he says. Atteberry prefers 15-year mortgages written in 2003, when, he says, underwriting standards were high and loan-to-value ratios were 80%or lower. Because the holders of those mortgages already have substantial equity in their homes, he says, they are less likely to default.

While Atteberry has found opportunities in agencies, he is staying out of Treasuries, the other conservative corner of the fixed-income market (he does have a small exposure to Treasury inflation protected securities). In fact, FPA New Income has refused to buy Treasuries for five years. "In 2003, we said we didn't see any value," says Atteberry. "So we started a buyers' strike."

Treasuries have struggled this year as bond investors grew concerned that future inflation would drive down their value. Atteberry agrees. "The Fed has put a tremendous amount out there, into a market they're manipulating," he says. "It's a bubble -- I know it's going to burst, I just don't know when."