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Morgan Keegan's Kelsoe Falls From Top Ranking on Subprime Rout

Jim Kelsoe, a top-ranked junk-bond fund manager since 2000, dropped to last place this year because of losses tied to mortgages for people with poor credit.

Kelsoe’s $1.1 billion Regions Morgan Keegan Select High Income Fund fell 4.2 percent from the beginning of 2007 as defaults on subprime home loans reached a five-year high. The mutual fund had 15 percent of assets in the subprime market and at least the same amount in other mortgage debt in May.

The High Income fund got a boost from the holdings for seven years and now “it’s very easy to be critical” of the investment decision, Kelsoe said in an interview from his office at Morgan Asset Management Inc. in Memphis, Tennessee. The fund had as much as 25 percent of assets in subprime-related securities in 2005.

Kelsoe’s fund ranks last of 93 high-yield rivals and it’s the eighth-worst performer this year of more than 550 U.S.-based bond funds tracked by Bloomberg. Losses accelerated in June after the collapse of two hedge funds run by Bear Stearns Cos. partly because of bad bets on bonds linked to subprime mortgages.

The $1 billion Regions Morgan Keegan Select Intermediate Bond Fund, which Kelsoe manages, also is the worst in its class, down 2.1 percent this year including reinvested dividends.

“A lot of mutual funds didn’t own much of this stuff,” said Lawrence Jones, an industry analyst at Chicago-based research firm Morningstar Inc., referring to the subprime market. The Morgan Keegan fund “is the one real big exception.”

The 44-year-old Kelsoe said that, like fund managers drawn in by Internet stocks at the start of the decade, an “intoxication” with high-yield subprime investments kept him from pulling out completely. Subprime mortgage bonds rated BBB, or investment grade, yielded 2.05 percentage points more than benchmarks in February, compared with 1.53 percentage points for BB-rated, or junk, corporate bonds, according to JPMorgan Chase & Co. in New York.

Morningstar cut its rating on Kelsoe’s High Income fund this month to three stars from four stars, citing above-average risk and underperformance. The highest grade is five. The fund has a one-year Sharpe ratio of minus 0.9, compared with 1.86 for its peers. A higher ratio means better risk-adjusted returns.

The average high-yield fund has gained 2.9 percent this year, according to Morningstar. The top-performing $4.1 billion Pioneer High Yield Fund, run by Andrew Feltus at Boston-based Pioneer Investment Management Inc., has gained 9 percent.

Kelsoe, who has worked at Morgan Keegan for the past 16 years, favors bonds backed by assets such as aircraft leases, and mortgage loans, as well as collateralized debt obligations, or CDOs, instead of corporate bonds, which made up only 21 percent of the fund in March. The $9.5 billion Vanguard High- Yield Corporate Fund, by contrast, has 92 percent of its assets in corporate bonds last month.

The strategy helped Kelsoe avoid getting pummeled by companies dragged down by concerns about accounting scandals at energy trader Enron Corp. in 2001 and phone company WorldCom Inc. the next year. A large part of his outperformance in recent years came from purchases of beaten-down aircraft-lease bonds after the Sept. 11, 2001, terrorist attacks, Morningstar’s Jones said.

Kelsoe, who graduated from the University of Alabama in Tuscaloosa, started managing the High Income fund in 1999. Morgan Asset Management is a unit of Birmingham, Alabama-based Regions Financial Corp.

Kelsoe’s fund rose 17 percent in 2000, 18 percent the next year and 11 percent in 2002, outperforming 99 percent of its competitors. Since the start of the decade, the fund climbed at an average annual rate of 12 percent, compared with 2.2 percent for the Standard & Poor’s 500 Index of U.S. stocks.

The fund is declining this year amid surging delinquencies on mortgages that may cause bond investors to lose about $100 billion in principal, according to estimates from analysts at New York-based Citigroup Inc.

Kelsoe had $4 million at the end of last year in a security backed by second mortgages that Goldman Sachs Group Inc. created in January 2006. The bond was downgraded twice this year by Moody’s Investors Service to the lowest rating.

Another holding was an unrated piece of a CDO overseen by Deerfield Capital Management LLC that was sold a year ago by Royal Bank of Scotland Group Plc. The $4.8 million security, which a semi-annual report listed with a 15 percent coupon, is mostly backed by subprime and “mid-prime” mortgage securities.