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It's Hard to Find a Serious Weakness in This Bond Fund

We’ve upgraded Western Asset Core Bond's Analyst Rating to Gold, thanks to its improved Parent rating, outstanding fixed-income staff and resources, and fine long-term performance.

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The following is our latest Fund Analyst Report for Western Asset Core Bond (WATFX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

It is hard to find a serious weakness in Western Asset Core Bond. Morningstar recently raised the Parent rating for Legg Mason, Western's owner, to Positive, and the fund scores well on our other pillars. We are therefore raising its Morningstar Analyst Rating to Gold.

Western Asset is one of the premier fixed-income shops in the industry and can command research resources that are commensurate with this status. Of a grand total of 126 investment professionals, 28 are devoted to broad market strategies, another 28 to emerging markets, 17 to high-yield, 21 to investment-grade credit, and 11 to structured products, among others. These numbers make it one of the better staffed asset managers among its competitors.

This large and diverse team is tasked with contributing to developing Western's investment outlook and executing it within the investment constraints of its various offerings. Senior members of the investment team, under the leadership of CIO Ken Leech, form a U.S. broad strategy committee that sets the firm's positioning on rates, yield curve, and sectors, among others. These forecasts have more often than not hit the mark. Once these themes are set, portfolio managers implement them. This part of the process has two aspects. Sector heads and individual analysts help managers with security selection, and the latter effect portfolio construction with the use of Western's risk system, which took multiple years to complete after its 2010 beginning. That system is notably important here given its utility in helping this fund's managers in their aim to diversify sources of risk.

Western's difficulties during the 2008 financial crisis served as a wake-up call, the firm retooled its approach thereafter, and the fund's performance has been excellent since then. Even including the fund's rather dismal performance in 2008, though, its annualized 10-year return of 5.11% as of Nov. 30, 2017, beat its average peer by close to 180 basis points. That's a remarkable result given that, unlike many of its peers, the fund's mandate precludes it from buying below-investment-grade paper.

Process Pillar: Positive | Maciej Kowara 12/11/2017
There is nothing inherently differentiated about the fund's investment process, but its managers have been able to execute it better than most. The fund merits a Positive Process Pillar rating. On the surface, the fund's process resembles many of its peers'. It combines a macro outlook--rates, shape of the curve, economic, monetary, and fiscal developments--with individual security selection based on fundamental research. The fund's benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index, but it will go far and wide out of the index. Its main constraints are that purchases be of investment-grade quality and that its duration stay within 20% of the index's.

The fund will act on its convictions but tempers its views with a healthy dose of skepticism toward management's forecasting abilities. This has been most notably on display with the fund's duration positioning. Western was much more circumspect about expectations that rates were going up in the years following the financial crisis, and for the past several years kept the fund’s duration close to the benchmark's. That attitude has acted as an implicit risk control. The strategy has also looked to control risk by maintaining diversification among its active bets. The fund embraces out-of-index sectors, such as nonagency mortgage-backed securities and emerging markets, among others, but does not want the risks of any one sector to dominate.

As of Nov. 30, 2017, the fund's largest positions were agency MBS, at 36.9%, investment-grade corporates at 21.8%, and U.S. Treasuries at 16.5%. The Treasuries position represented the fund’s largest underweighting to the index (37%) in terms of market value and represented a decline from 29% at the end of 2016. That big drop notwithstanding, the fund's Treasuries stake contributed more than any other sector to the fund's overall duration as of Nov. 30, 2017, more in fact than it did at the end of 2016. There are three interwoven themes behind this stance. First, Western remains committed to the theme that inflation has been missing in action despite the Fed's seemingly ever-frustrated expectation that it’s just around the corner; the fund has thus favored the long end of the yield curve. Second has been a forecast of solid global growth, which favors spread sectors. This in turn feeds into the third aspect of Western's calculus: If the fund can get a lot of duration with relatively modest amount of capital, it can deploy more money to spread product. The biggest beneficiaries of the reduction in Treasuries was the fund's 37% agency mortgage stake, which stood at 23.2% on Dec. 31, 2016; valuations looked more attractive in that sector after the market priced in announcements that the Fed would start reducing MBS holdings. The fund also increased its emerging-markets stake to 7.3%, up from 4.8% at the end of 2016.

Performance Pillar: Positive | Maciej Kowara 12/11/2017
The fund earns a Positive Performance Pillar rating for its excellent post-financial-crisis returns.

The fund's experience during the Great Recession of 2007-08 can be summarized with one word: awful. Ever since, however, it has been great. The fund's institutional share class outperformed its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, in all but one calendar year between 2009 and 2016; the same was true of its (unique) peer-relative returns. This improvement can be attributed to two factors: One is that Western Asset did some serious soul-searching and decided to reshape itself from a decidedly "spread is all that matters" shop to a more diversified approach. Secondly, the credit and spread markets have generally been strong performers since the crisis, and while Western may be more diversified than it was a decade ago, a certain bias toward spread product does remain in its DNA. Firm-provided performance attribution reveals that over the five years ended Sept. 30, 2017, two thirds of the fund's outperformance came from overweighting spread product, with the remaining third due to successful macro calls. Still, one can't argue with the results. As of Nov. 30, 2017, the fund's 10-year annualized return of 5.14% outperformed its benchmark by 115 basis points, and its average unique intermediate-term bond peer by 80 basis points.

People Pillar: Positive | Maciej Kowara 12/11/2017  
The fund earns a Positive People Pillar rating for the experience of its management team, as well as the breadth and experience of the Western investment team behind it.

This fund has four named comanagers. The most influential among them is Ken Leech, Western's CIO, who stepped off of the fund for a few years but has otherwise been involved since joining Western in 1990. Leech's role revolves more around the big-picture themes the fund implements rather than deciding on issues of implementation. Of the remaining three comanagers, two are old hands: Carl Eichstaedt and Mark Lindbloom have been at the fund since 1994 and 2006, respectively. The Eichstaedt-Leech-Lindbloom trio won the Morningstar Fixed-Income Manager of the Year award in 2014. They were joined by Julien Scholnick in 2016. Scholnick is clearly being groomed as part of the next generation of Western's leadership, given the tenures of the three more senior managers.

Behind the management team stands Western Asset's investment team, which is one of the larger among its competitors'. Overall head count for the firm's investment professionals stands at 126, which lets the firm devote considerable human capital to each part of the market in which the firm invests. The average member of the whole team has 22 years of industry experience, 11 of which have been with Western.

Parent Pillar: Positive | 03/06/2017
Legg Mason operates a multiaffiliate model, in which it handles marketing and distribution while affiliates--all owned by Legg Mason--are given investment autonomy. There are now nine affiliates: Prominent ones include Western Asset, a fixed-income investor, and ClearBridge Investments, a quality-driven fundamental equity shop. Other affiliates include Royce & Associates and Brandywine Global. Western Asset, ClearBridge, Royce, and Brandywine Global account for about 85% of Legg Mason’s assets under management, and each has a strong investment culture and sticks to its areas of expertise. To reflect the strength of its underlying affiliates’ investment cultures, Legg Mason’s Parent rating has been upgraded to Positive from Neutral.

Several of Legg Mason’s prominent funds performed poorly in the 2007-09 financial crisis, leading to steep outflows and personnel turnover. These included Western Asset Core Bond as well as Bill Miller’s Legg Mason Value Trust. Western Asset has since invested heavily in its risk-management systems to mitigate woes in the future. Further, Legg Mason has diversified away from star managers: Legg Mason Capital Management was merged into ClearBridge in 2013; Miller and Legg Mason severed ties in February 2017. CEO Joe Sullivan has helped make the firm more coherent and focused since assuming the role in 2012, but tough times could trigger changes that suggest less autonomy at the affiliate level.

Price Pillar: Positive | Maciej Kowara 12/11/2017
The fund merits a Positive Price Pillar rating. The bulk--more than 90%--of its assets are in two institutional share classes which are both ranked as below average in terms of fees relative to their distribution channel.

Maciej Kowara does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.