U.S. pension funds continue to flock to core-plus fixed-income strategies in hopes of achieving A+ returns by adding bonds rated BB to the mix.
Consultants have seen increased interest in the strategy as many pension funds look to boost returns without assuming the high level of risk usually associated with junk bond investing.
"It's a lot more common across the spectrum to employ a core-plus manager," said Thomas M. Anichini, director of manager research at the Chicago office of William M. Mercer Investment Consulting Inc.
Third quarter help
The fizzled high-yield bond returns of the third quarter seem to have helped core-plus managers gain momentum with more conservative pension funds. Also, the depressed high-yield market that followed the third-quarter Russian bond default whetted sponsors' appetites for small exposures to high-yield bonds, which showed a promising comeback earlier this year.
Mr. Anichini has observed more core-plus searches than U.S. domestic core bond searches so far this year.
Doug Moseley, an analyst at Cambridge, Mass.-based New England Pension Consultants, believes the trend is driven by consultants breaking down bond asset allocations beyond the traditional U.S. core bond strategy.
The only cases in which his firm employs core-plus portfolios are when an allocation to bonds is too small to break out further into a dedicated high-yield portfolio, or if a client already has multiple managers handling its fixed-income portfolio, Mr. Moseley added.
The trend is not limited to a specific type of plan, although larger public and corporate plans are more likely to use a separate high-yield manager, while Taft-Hartleys often are dragged to core-plus "kicking and screaming," consultants said.
Bill Puckett, investment officer for the Teachers' Retirement System of Oklahoma, Oklahoma City, hired two core-plus managers last month to manage $500 million or one-third of the $5.5 billion fund's bond portfolio.
"It just didn't make sense to our board to hire a separate high-yield bond manager," he said. The core-plus strategy allows managers to invest in junk bonds at the level where they are comfortable, he added.
PIMCO and Loomis, Sayles will be allowed to manage up to 10% of their $250 million portfolios in high yield, an amount that may increase in time. The goal is to pick up a little yield with less risk, he said.
Battle of the bonds
The popularity of the bond strategy has left some dedicated high-yield fixed-income managers calling for a battle of the bond strategies.
"Hiring a high-grade manager to market time the high yield market is like ordering a pasta dish at your favorite steakhouse," said Christian Noyes, vice president and partner of Penn Capital Management Co., a Cherry Hill, N.J.-based, dedicated high-yield bond manager with $300 million under management.
In his research comparing the performance and investment strategies of the two bond approaches, Mr. Noyes has concluded that dedicated high-yield is the wiser choice for plan sponsors.
The initial difference is between the investment philosophies and experience of the managers running the portfolios. While core-plus managers are used to studying interest rates, high-yield managers are more focused on credit management, which is a science not an art, he said.
"If you are going to allow for high-yield investments, hire a high-yield specialist who is focused on analyzing company fundamentals and overall credit-worthiness on a daily basis. The high-yield specialist is going to make the plan's participants much more money than the high-grade manager will in that area," he said.
The risk and return profiles also differ for each -- with core-plus managers sticking to bonds rated BBB and BB, and dedicated high-yield bond managers dipping down to B and lower. The portion of a portfolio core-plus managers can dedicate to high yield is generally between 10% and 25%, according to managers and consultants.
In terms of risk, junk bond portfolios are less correlated to traditional bond and equity markets offering more diversification, but do carry a default risk, Mr. Noyes said.
Bonds rated BBB and BB typically offer 1% to 3% additional returns over traditional high-grade fixed income, while high yield offers 3% to 10% returns above high-grade bonds, he said.
"There seems to be more potential for higher returns and clearly potential for higher volatility," said Mercer's Mr. Anichini.
At Metropolitan West Asset Management, Los Angeles, Managing Director Stephen M. Kane views significant opportunities in investment- grade bonds and doesn't feel the need to invest in high-yield bonds.
The core-plus portfolio manager said there are times to own high yield and times not to. When the stock market and/or corporate earnings are volatile and during recessions, junk bonds are not attractive holdings.
While default rates are creeping up, Mr. Kane's stop-and-go light is flashing yellow rather than red. His firm manages $1 billion in core-plus portfolios and doesn't go below securities rated BB.