The Other Mr. Bond
A rare talk with Ken Leech of Legg Mason, who now oversees $520 billion in fixed-income assets.
by Jon Birger

(FORTUNE Magazine) - Think Legg Mason and the first name that pops to mind is Bill Miller, the ace equity-fund manager whose Value Trust fund just beat the S&P 500 for the 15th consecutive year. Or maybe Bruce Sherman, the Legg money manager who recently forced Knight Ridder to put itself up for sale. But Legg Mason has another star in its ranks, only this one doesn't like seeing his name in the paper.

S. Kenneth Leech, chief investment officer of the company's Western Asset Management division, has long been one of the investment world's under-the-radar luminaries. Since 1996 he's helped grow Western's assets under management from $18 billion to $240 billion, and in 2004 he was honored as Morningstar's fixed-income-fund manager of the year. Yet Leech is a virtual unknown outside the bond world, in sharp contrast to his oft-quoted archrival, Pimco's Bill Gross. That's just fine with Leech. "Bill likes the press, and they like him," Leech told FORTUNE in a rare one-on-one interview in December. "Our organization has never sought the limelight."

Unfortunately for Leech, the limelight is about to find him. With Legg's recently completed acquisition of Citigroup's asset-management unit, Western has now passed Pimco in fixed-income assets under management, with $520 billion, most of it in institutional accounts. Pimco says it could retake the lead when it integrates assets from corporate parent Allianz. For now, though, the Citigroup deal has made Western the biggest bond house on the planet and given Leech a new moniker, courtesy of Bill Miller. "Ken is now the King of Bonds--the KOB," Miller quipped at a recent Legg Mason investment symposium. That unofficial crown confers influence. If, for example, word gets out that Leech thinks interest rates are headed higher, other fund managers will look to follow and sell their long-term bonds.The KOB himself is nonplussed by his ascension. "Things haven't changed a lot," Leech says. Still, he acknowledges that the doubling of Western's assets could make the firm less nimble: "On the margins, the challenge of managing and performing with more assets is more difficult."

In recent years Western's performance has been every bit as good as Pimco's. Western Asset Core Plus, the firm's largest mutual fund (minimum initial investment: $1 million, or $2,500 through Schwab or Fidelity), has been a consistent market beater, with three- and five-year average annual returns of 6.61% and 7.40%. That compares with 4.81% and 6.53% for Pimco Total Return, Gross's flagship fund. "Ken is a brilliant guy," says Michael Hyland, a Wall Street bond veteran who was Leech's boss at First Boston in the early 1980s. "But he's very different from Bill Gross."

Leech is press-shy; Gross is a media magnet. Leech is afraid of heights; Gross owns a house on a cliff. Leech is a competitive bridge player; Gross's game of choice is blackjack. But the biggest difference may be strategic. Gross has excelled by making well-timed interest-rate bets on Treasury or mortgage bonds. Leech owes his success to credit-quality bets in the corporate bond market. "It's a different bent," Hyland says. The former requires a keen reading of macroeconomic trends, while the latter relies on bottom-up research on hundreds of corporate borrowers.

That's not the only difference. The markets for Treasuries and mortgage-backed securities are huge and liquid. The corporate bond market is smaller and thus more difficult for a big firm to navigate--at least without affecting the prices of the bonds it is trading. That's why, even before the Citigroup deal, Western was increasingly using credit derivatives to get exposure to corporate bonds, says Jeff Hussey, director of U.S. fixed income at pension giant Russell Investment Group. Derivatives are not a panacea, though, and Western may still have to adapt, perhaps by making more sector-wide calls on credit and fewer on individual companies, says Hussey.

Whether it's a concession to size or merely a reading of the market, Leech has in fact cooled a bit on corporate bonds. He now describes himself as neutral on them, though he's still more bullish than many of his peers. The prevailing wisdom is that the average spread between Treasury bond yields and corporate bond yields--now about 90 basis points, down from 235 in September 2002--is too narrow considering the risk in the corporate market. Leech disagrees. "It's a reflection of the positive economic environment," he says. In his Legg Mason talk, he elaborated: "You had the Asian Contagion; next it was the U.S. recession; and then there was ... the entire corporate governance, Enron, WorldCom bottom. Are you really supposed to compare today's spreads with those two or three years ago?"

Leech believes the biggest bond opportunity right now is in mortgage bonds. As for interest rates, he's not expecting any big swings. The reason? Inflation is under control, despite the recent spike in oil prices. "The story of interest rates is the story of inflation," he said in his presentation. "Our basic perspective is that the Fed has in fact achieved price stability."

If Leech has one worry, it's the prospect of an inverted yield curve. Yield-curve inversion occurs when short-term bonds pay more than long-term ones. The yield curve inverted slightly in late December. Historically, inversions have been a near-perfect predictor of economic slowdowns and recessions. With this history looming over the market, Leech thinks the Federal Reserve may be nearly done hiking short-term rates. "It's a terrific indicator," Leech says of the link between inverted yield curves and recession. "That's why the Fed should be cautious about continuing to raise rates. We hope they won't." Top of page