<!-- Swiftype Variables -->

Special report

High-yield fixed-income strategies once again reign supreme

Emory Zink, fund analyst, Morningstar
‘Risk-on’ strategies overtook long-duration bonds in the last quarter of 2016, says Emory Zink, fund analyst, fixed-income strategies at Morningstar.

High-yield strategies were again the top performers in fixed income for the year ended March 31, according to Morningstar Inc.'s separate account/collective investment trust database.

Nine of the top 10 fixed-income strategies in the separate account universe for the 12-month period were in Morningstar's high-yield bond category, continuing a trend from the year ended Dec. 31, when high-yield strategies occupied eight of the top 10 spots.

Long-duration bond strategies dominated Morningstar's list for the first three quarters of 2016 but long duration gave way to “risk-on” strategies at the end of 2016 as the energy sector recovered and fixed-income managers began to expect more frequent federal funds rate increases, said Emory Zink, fund analyst, fixed-income strategies at Morningstar in Chicago.

“The Federal Reserve raised rates in late 2016 and again in March, but the yield curve actually flattened in that period, which indicates a lot of investors already expected those rate moves. It was already priced in,” Ms. Zink said.

On March 15, the Federal Open Market Committee increased the federal funds rate by 25 basis points to a 0.75% to 1% range, echoing a Dec. 15 move that also raised rates by 25 basis points.

The recovery in energy prices was also a contributing factor in high yield's second consecutive quarter of dominance, Ms. Zink said. “In the fourth quarter of 2015 and first quarter of 2016, there was a lot of energy stress. One of the reasons high yield looks attractive (in the first quarter of 2017), energy has recovered and the energy names have continued to outperform from the previous quarter,” she said.

Ms. Zink said there was some uncertainty in market sentiment during the first months of 2017, following new legislative priorities in the U.S. that accompanied the election of a new president, but “a lot of managers are taking a 'wait-and-see' approach. They have expressed an expectation of volatility but volatility equates to opportunity. They're calculating risks and remaining open to a gamut of possible positions,” Ms. Zink said.

The Credit Suisse High Yield index returned 17.4% for the year ended March 31, the median domestic high-yield return was 13.81% and the median return for the entire domestic fixed-income universe was 1.6% for the period.

TCW Group Inc.'s AlphaTrak strategy claimed the top spot on the one-year list with a gross return of 27.61%. AlphaTrak was in fourth place for the year ended Dec. 31.

'Less trafficked'

TCW describes AlphaTrak as an enhanced equity indexing strategy that uses S&P 500 futures to get equity index exposure, while actively managing the collateral backing the futures using short-term fixed-income securities that enhance returns above the S&P 500 index. Morningstar classifies AlphaTrak as an ultrashort bond strategy.

“There has been an incremental amount of returns generated by navigating attractive but less-trafficked parts of the fixed-income market, and that's gone a long way in providing the strategy with the performance to put it in this particular ranking,” said Bryan Whalen, group managing director, U.S. fixed income, at TCW Group in Los Angeles.

AlphaTrak's fixed-income component is diversified across bond issues including Treasuries, short-term corporate bonds, asset-backed securities, and agency and non-agency mortgage-backed securities.

New York-based MacKay Shields LLC's select high-yield composite was second on the list with a one-year gross return of 27.39%.

DDJ Capital Management LLC's Total Return Credit II Composite was in third place with a gross return of 22.63%, while a 20.95% gross return put DDJ's U.S. opportunistic high-yield composite in fifth place.

Using a deep value approach that prioritizes individual security selection over sector weighting, these strategies are “concentrated portfolios focused generally on middle-market companies that offer a yield premium to the overall market,” said David J. Breazzano, the Waltham, Mass.-based chief investment officer, president and lead portfolio manager of the total return credit and opportunistic high-yield strategies.

These DDJ portfolios “have the same analyst team and the same process, which leads to pretty strong security selection. Our analysts have the freedom to look up and down the capital structure and when a sector, such as health care, is out of favor it gives us an opportunity to identify value in that sector,” said Benjamin J. Santonelli, assistant portfolio manager on both the total return credit and opportunistic high-yield strategies.

The opportunistic high-yield portfolio was underweight energy and overweight health care in a period when many investors took the opposite approach, said John W. Sherman, assistant portfolio manager of DDJ's opportunistic high-yield strategy. Mr. Sherman said the firm's high-conviction security selections are based on “the best risk/reward potential we see. Over the past year, we saw better relative value in health care and that's what drove our allocation. And due to superior credit selection, we were able to generate better returns.”

Completing the top five, Philadelphia-based Penn Capital Management Co. Inc.'s distressed total return strategy was fourth on the list with a one-year gross return of 22.26%.

High-yield strategies also dominated the list of top performers for the five years ended March 31. Seven of the top 10 were in Morningstar's high-yield bond category, two fewer than in the year ended Dec. 31.

The annualized return for the Credit Suisse High Yield index was 6.65% for the five years ended March 31, the median domestic high-yield bond return was 6.61% and the entire domestic fixed-income universe returned 2.93% for the five years ended March 31. (All figures for periods of more than one year are compound annualizes.)

TCW's AlphaTrak strategy led the five-year list for the third consecutive quarter with a gross return of 15.92%, and TCW's opportunistic mortgage-backed securities strategy was in second place for the second quarter in a row with 10.63%.

'Credit curing'

TCW's Mr. Whalen said the opportunistic MBS strategy, which is in Morningstar's high-yield bond category, is 100% focused on the non-agency residential MBS market, with the underlying mortgages primarily issued between 2004 and 2007.

“The underlying securities continue to undergo a credit-curing process, such that the level of delinquent mortgages, and consequently, the amount of losses these pools experience continue to decline, and that is putting an inverse upward pressure on prices, and that higher pricing is translating into good performance for the holdings,” Mr. Whalen said.

Morgan Stanley (MS) Investment Management's Institutional Fund Trust High Yield Portfolio was in third place, with an annualized gross return of 9.38%.

The strategy invests in middle-market companies with less than $1 billion in total outstanding debt, and is “primarily composed of single B or CCC issues,” said Richard Lindquist, the New York-based managing director, head of high yield and lead portfolio manager of the high-yield portfolio.

“Ratings agencies have a bias for size and they rate the bigger companies two or three notches higher but the default rates don't bear out that bias. Middle-market issuers typically yield 100 to 150 basis points more than the bigger companies and tend to have about the same default rates so you're being overcompensated for the risk in this part of the market,” Mr. Lindquist said.

The bonds in the portfolio generally have a five- to seven-year maturity profile with a duration close to three years, which Mr. Lindquist said is about one year shorter than the index, and the shorter duration was attractive during market cycles when investors were worried about rising rates.

For the five-year period ended March 31, “there were a lot of pitfalls. Energy was the highest defaulting sector in 2015 and 2016, but the best-performing sector in 2016, and the ability to manage through that played a big role in relative performance. The key is to minimize defaults and credit losses by doing good fundamental credit research,” Mr. Lindquist said.

New York-based Nomura Corporate Research and Asset Management Inc.'s high-yield total return institutional strategy ranked fourth for the five years ended March 31, with a gross annualized return of 9.27%. The strategy was third on the list of top performers for the five-year period ended Dec. 31.

Pittsburgh-based Federated Investors (FII) Inc. (FII)'s high-yield composite rounded out the top five on the five-year list with 8.97% for the period.

Collective investment trusts

State Street Global Advisors' U.S. high-yield bond index led the collective investment trust universe, with a net one-year return of 15.37%.

The median return for fixed-income collective investment trusts was 1.21% for the year ended March 31.

Capital Group Cos.' global high-yield fund claimed the second spot in the one-year rankings with a net return of 15.33%, followed by J.P. Morgan Asset Management (JPM)'s JPMCB public bond fund with 14.97%; Fidelity Institutional Asset Management's high-yield core institutional strategy at 14.35%; and Loomis Sayles & Co. LP's high-yield conservative strategy in fifth place with a net return of 14.14%.

J.P. Morgan's JPMCB corporate high-yield strategy claimed the top spot on the five-year CIT list with an annualized net return of 7.11%, followed by Eaton Vance (EV) Corp.'s EB high yield at 7.04%.

Three additional J.P. Morgan strategies completed the top five. JPMCB mortgage credit opportunity was in third place with an annualized five-year return of 6.94%, JPMCB high-yield fund ranked fourth at 6.46% and JPMCB public bond fund placed fifth on the five-year list with 6.19%.

The five-year median return for the CIT universe was 3.06%.

All data for Pensions & Investments' top-performing managers report are provided from Morningstar's global separate account/collective investment trust database. The data for the rankings on which this story is based were pulled April 27.