Investment market turmoil led to strong returns in the third quarter for fixed-income managers with longer durations and higher quality securities, according to the Pensions & Investments' Performance Evaluation Report.
Whether by investment mandate or investment decision, the majority of the top separate account managers in the PIPER database had durations that were longer than the market.
Also, holding higher quality securities proved beneficial in a quarter where investors were dumping their less liquid, lower quality securities.
The same trends that led to problems for leveraged hedge fund managers like Long-Term Capital Management LP were a boon for selected fixed-income managers.
And fixed-income managers that led the third-quarter report are forecasting lower interest rates as a result of continued global price disinflation or from actual deflation.
The median manager in the PIPER separate account long duration category reported a return of 5.6% in the third quarter, besting all other PIPER categories. In the same period, the Lehman Brothers Long Term bond index returned 5.9%. (All performance numbers in this story are as of Sept. 30, and all returns for periods of more than one year are annualized.)
For the one-year period, the median long duration manager reported a return of 16.1%, while the Lehman Brothers Long Term bond index returned 18.6%.
Fixed-income returns were skewed by the same forces that hit fixed-income arbitrage managers: a flight to quality as world stock markets fell, resulting in a diminished trading liquidity among large segments of the fixed-income markets.
Areas such as convertible bonds were hit hard by a widening of fixed-income yield spreads relative to U.S. Treasuries, and by falling U.S. stock prices.
But in absolute terms, PIPER separate account managers performed well. The median PIPER separate account fixed-income manager reported a return of 3.9% in the third quarter, and 10.6% for the 12 months.
Broad market fixed-income indexes performed even better. The Lehman Brothers Aggregate bond index returned 4.2% in the quarter and 11.5% for the year. The Salomon Brothers Broad Bond Index returned 4.1% in the quarter and 11.5% in the year.
At least seven of the top 10 maintained long duration portfolios in the third quarter.
A regular leader among PIPER managers when interest rates are falling, Hoisington Investment Management Co., Austin, Texas,
was the top-ranked manager in the third quarter, reporting a return of 9.4% for its fixed-income composite. Depending on Hoisington's macroeconomic outlook for inflation, portfolios will be 100% invested in either long-duration U.S. Treasuries or in shorter term cash-like securities.
DISINFLATION LIKELY
Hoisington's portfolios continue to be invested in long-term Treasuries, because executives there believe the long-term trend on inflation is down, said Lacy H. Hunt, executive vice president.
Disinflation, or a falling rate of inflation, is the most likely scenario, with deflation, or falling prices, a bigger risk than inflation, Mr. Hunt said.
Hoisington's fixed-income composite was ranked second for the one-year period by PIPER, with a return of 28.6%; fourth for the three years, with an annualized return of 14%; sixth over five years, with a return of 10.2%; and fifth over 10 years, with 12.7%.
(The Lehman Brothers Aggregate and the Salomon Brothers Broad bond indexes both returned 8.7% over three years; 7.2% over five years; and 9.3% over 10 years).
ABB Investment Management Corp.'s long-duration government composite and Western Asset Management's long-duration composite tied for second among PIPER separate account fixed-income managers in the quarter, with each reporting a return of 8.9%.
Stamford, Conn.-based ABB saw strong returns from the firm's aggressive extension of fixed-income duration, to about 90% of its possible maximum, said Anders Ekernas, president.
Moreover, ABB has been exclusively in U.S. government-backed bonds, he said.
OVERBUILDING ISSUE
ABB's managers invested in long-duration securities because they believe deflation is on the horizon, as a result of overbuilding across the globe.
"The world has been adding capacity," in just about any segment of industry, such as automobiles, shopping centers and office buildings, Mr. Ekernas said. "You name it, we've built it."
But the law of diminishing returns means that each new unit of added capacity will produce less profit, with marginal capacity eventually reaching unprofitable levels, he said.
The United States is in a similar situation to that of Japan in the 1980s -- excessive growth from too-easy credit -- and the outcome will be similar as well, Mr. Ekernas said. The economy will slow significantly.
As a result of that view, ABB executives maintain an aggressive stance in terms of keeping its duration long, in anticipation of falling interest rates, he said.
ABB's long-duration government composite posted strong returns for other time periods, as well. It was ranked fourth over one year, with a return of 27%; third over three years, with a return of 15%; and third over five years, with 11.3%.
Similar to the view of portfolio managers at ABB, managers at Western Asset Management in Pasadena, Calif., are comfortable with a longer-than-benchmark duration, based on the expectation that global growth will be weak, said Ken Leech, chief investment officer.
Although Western Asset managers added some corporate bond issues and mortgage-backed securities, because trading spreads had weakened so much, they still have about 60% of portfolios in Treasury securities, Mr. Leech said. The remaining 40% is roughly split between corporate issues and mortgage-backed securities.
Western's long-duration strategy has fared well over longer time periods, ranking third for one year, with a return of 27%, second for three years, with a return of 16.1%; and fourth over five years, with 11%.
SHORTENING DURATION
Consistent Asset Management Co., Chadds Ford, Pa., is an active duration manager that also had lengthened the duration of portfolios, resulting in a fourth-place rank in the quarter, with a return of 8.4% for its CAMCO total return composite.
Daryl Hudson, chairman, said Consistent is a 100% U.S. Treasury security manager, and its quantitative strategy in the third quarter suggested its managers lengthen portfolio durations.
More recently, though, they have reduced durations to closer to a neutral position relative to benchmarks, he said.
NISA Investment Advisors LLC, St. Louis, ranked fifth with its long-duration fixed-income composite return of 8.2%
Jess Yawitz, chief executive of NISA, said the firm's portfolio managers saw a better risk/reward tradeoff in longer duration, high-quality securities, and positioned portfolios accordingly during the third quarter.
"We've chosen to own primarily Treasuries," Mr. Yawitz said.
More recently, though, the drop in liquidity in non-Treasury securities provided some opportunities in corporate securities, so they've been "selectively adding some corporates," he said.
NISA's long-duration strategy is a winner over a number of periods in PIPER. It ranked first for the one-, three-, five- and 10-year periods, with respective returns of 31.9%, 16.2%, 12.8% and 14%.
EMPHASIZE QUALITY
Jennison Associates Capital Corp., New York, ranked sixth in the quarter, with a return of 8.1% for its long bond active composite.
Thomas Doyle, executive vice president, said Jennison's focus on high-quality securities was the primary driver behind the results.
Jennison's executives believe long U.S. Treasuries provide protection during times of stress in the stock markets. "We look at long bonds as a good diversification for equities," Mr. Doyle said.
In the third quarter, that type of strategy benefited from market turmoil, he said.
Like NISA, Jennison has reduced its emphasis on high-quality securities in favor of lower quality issues. "We nibbled away as spreads widened," Mr. Doyle said.
Currently, portfolios are: 60% Treasuries, 20% corporates and 20% agency securities. Mr. Doyle said Jennison's portfolio managers tend to avoid mortgage-backed securities for long-duration accounts because it's difficult to find long mortgage-backed securities with call protection.
Jennison's long-bond active composite was ranked sixth in the one-year period, with a return of 22.6%; seventh over three years, with a return of 12.7%; seventh over five years, with 9.7%; and sixth over 10 years, with 12.3%.
IN DEFLATION CAMP
Redstone Advisors Inc., Wichita, Kan., returned 7.7% on its active-duration fixed-income strategy.
Redstone had invested mainly in Treasury securities in anticipation of falling interest rates, and out of concern about credit quality of corporate issues, said Marc A. Vincent, managing director.
Although Treasury prices have come back more recently, Mr. Vincent said that is more of a response to "almost panic buying of Treasuries" in the third quarter. "When that was over, you had some natural reversal" of prices, he said.
But the reasons for holding higher quality securities are still here, with Redstone managers still in the deflation camp, Mr. Vincent said.
Redstone's active duration composite also ranked seventh in the one-year period, with a return of 21.1%.
Stacy Braun Associates Inc., New York, and Smith Barney Capital Management, New York, ranked eighth in the quarter with a return of 7.1% each.
Stacy Braun's return was for its active duration composite, and Smith Barney's was for its domestic fixed income-long composite. Stacy Braun and Smith Barney executives could not be reached for comment.
Smith Affiliated Capital Corp., New York, ranked 10th in the quarter, reporting a return of 6.8% for its core-plus fixed-income composite.
John Rahill, vice president, portfolio manager and director of analytics, said Smith has been investing within a broad strategy since late last year. That strategy seeks a high-quality income stream that couldn't be taken away by mortgage prepayments, bond calls or credit defaults, Mr. Rahill said.
"It's worked out very, very well this year," he said.
A number of factors exist that could lead to falling prices in the United States, which would be bad for corporate America, he said.
"Deflation is a big risk here," he said. Inflation is low and earnings are suspect.
CONVERTIBLES CLIPPED
Some of the worst-performing fixed-income securities in the third quarter were convertible bonds.
Michael F. Carr, president of Carr & Associates, New York, said convertibles were victims of the flight to quality in the third quarter.
The unwinding of arbitrage strategies involving convertibles resulted in a big drop in convertible bond prices, he said, particularly in lower-quality and lower-yielding issues.
The firm avoided some of that as a result of its focus on higher quality, Mr. Carr said.
Carr's convertible securities composite was the top-ranked convertible manager in PIPER, with a return of -2.6% in the quarter. The First Boston Convertible Bond Index returned -10.8%.
Managers' investment positions are subject to change prior to publication.
