Core-plus fixed-income portfolios, battered by rising bankruptcy rates and weak overseas markets, are starting to see daylight.
After three years of volatile fixed-income markets that have damped down returns, particularly for more aggressive core-plus portfolios, performance finally started bouncing back in the fourth quarter.
Core-plus portfolios take up six of the top 15 slots in the Pensions & Investments' Performance Evaluation Report broad-market universe for managed accounts for the quarter ended Dec. 31. They are: Atlantic Asset Management LLC, Boston, returning 2%; TimesSquare Capital Management, New York, 1.5%; Strong Capital Management Inc., Menomonee Falls, Wis., 1.2%; Julius Baer Investment Management Inc., New York, 1.2; Hartford Investment Management Co., Hartford, Conn., 1.2%; and Western Asset Management Co., Pasadena, Calif., 1.1%. That compares with a meager 0.05% return for the Lehman Brothers Aggregate index.
Strikingly, all of those managers' composites were in the dumps in the third quarter. All experienced below-median returns, with only Western ranking as high as the sixth decile, while the others fell anywhere from the eighth to the 10th decile in the PIPER broad-market universe during that quarter.
For example, Strong Capital's core-plus composite rebounded from bottom decile to top from the third to the fourth quarter. The reason, explained Frank Koster, a Strong fixed-income portfolio manager, was simple: Strong maintains a strategic minimum allocation to high-yield bonds of 10%, which the firm hugged for the last three quarters of 2001. In response to client demands, Strong now is developing a core-plus product that is more opportunistic and caps the high-yield weighting at 10%, Mr. Koster said.
Still, improved returns of the last quarter could not make up for a difficult year. Strong ranked in the seventh decile of the broad-market universe for the year ended Dec. 31. Of the core-plus portfolios, only Western's 9.8% return ranked in the top 15 of 251 bond strategies in the broad-market rankings. The Lehman Aggregate - the typical benchmark for core-plus portfolios - returned 8.4% for 2001.
It's not supposed to be that way. Core-plus portfolios are expected to outperform traditional core fixed-income portfolios by taking extra risk, typically through allocations to high-yield bonds, emerging market debt or international bonds. In the past few years, U.S. pension plans have shifted billions of dollars to the category, said David Holmes, principal, Mercer Manager Advisory, Louisville, Ky.
But the reality is that many of portfolios have failed to live up to their promise.
"Core-plus can turn into core-minus," said Gail Seneca, chief investment officer and managing partner of Seneca Capital Management LLC, San Francisco, which manages $4.5 billion in such portfolios. "For a three-year running period, it has been a real problem," she said. "It has been a big concern for clients now, who wonder whether or not the high-yield asset class has any strategic role - or tactical role, for that matter."
Ms. Seneca declined to discuss the performance of her core-plus portfolios, noting they were individually tailored for clients. However, PIPER data reveal her composite figures for Seneca's value-driven fully discretionary portfolios ranked in the top quartile for the fourth quarter but in the bottom decile for the year.
"Some plan sponsors are rethinking if core-plus is what they want to do," said Rosalind M. Hewsenian, managing director, Wilshire Associates, Santa Monica, Calif. Ms. Hewsenian was unaware of any pension executives who have abandoned the strategy.
Core-plus portfolios have been widely touted, partly as a way to enhance returns and partly as a way to give more discretion to fixed-income managers and to avoid making individual allocations to high-yield or international bonds.
But a bruising market for lower-quality debt and the dollar's continued rise have made it difficult for some core-plus managers to add value. For much of the past three years, the fixed-income market has been a roller coaster.
Over the past three years, high-yield bonds have returned a dismal 0.4% on an annualized basis, according to the Salomon High-Yield index. In comparison, the Lehman Aggregate returned 6.3% annually.
Last year, when the Lehman Aggregate returned 8.4%, high-yield debt returned 5.4%, weighed down by telecom company defaults and downgradings early in the year, and Enron Corp.'s fourth-quarter bankruptcy filing. Meanwhile, international bonds - as measured by the Salomon Non-U.S. World Government index - returned -3.5%.
"So wherever you went for plus was going to hurt in 2001," explained Michael Rosen, principal, Angeles Investment Advisors LLC, Santa Monica, Calif.
Nor do many core-plus managers use international debt. "The problem with non-dollar debt is very few people have the resources to do it, and do it well," said David Morton, associate director, fixed-income research, BARRA RogersCasey, Darien, Conn.
The bottom line is that core-plus managers that took a more aggressive approach with higher allocations to high-yield debt or non-dollar debt allocations suffered, while firms with more conservative approaches fared better.
Take Loomis, Sayles & Co., Chicago. The company has a higher component of high-yield bonds in its portfolio than many core-plus managers, averaging about 15% to 17% of assets, said Curt Mitchell, fixed-income portfolio manager. Those bonds dragged down the portfolio, which returned 6.8% for the year, landing it in the last decile of the broad-market universe.
In contrast, more conservatively managed core-plus portfolios fared better. For example, BlackRock Inc., New York, which manages $14 billion in core-plus fixed-income assets, returned 8.9% last year - good enough to make the cutoff for the third decile. BlackRock limits the amount it will go outside core assets to 10%, and it will go to zero if firm officials don't think they can add value from those assets, explained Barbara Novick, managing director and director of marketing and client services.
Similarly, Metropolitan West Asset Management, Los Angeles, has kept its high-yield exposure to a minimum, said Stephen Kane, managing director. Most of the firm's high-yield exposure today "is from formerly investment-grade companies that have slipped into the non-investment-grade world," Mr. Kane said. As a result, the firm's composite also returned 8.9% in 2001.
Meanwhile, Pacific Investment Management Co., Newport Beach, Calif., took a totally different approach with its total return fund, which produced 9.4% last year, placing it in the second decile of the PIPER broad-market universe.
Positioned for short interest rates to fall, the portfolio gained when the Federal Reserve cut rates 11 times last year. "We felt the Fed would ease much more aggressively, and much more than the market anticipated," said Mark Kiesel, senior vice president. Meanwhile, the firm gained by overweighting mortgages, and from international bonds, despite the strong dollar.
While core-plus portfolios told an interesting story in last year's volatile market, other strategies also performed well. For example, a corporate fixed-income strategy run by Taplin, Canida & Habacht, Miami, ranked in the top decile for both the fourth quarter and the year, returning 2.5% and 12.3%, respectively. The manager's performance was greatly helped by opportunistic buying after spreads widened following the Sept. 11 World Trade Center attacks, said Bill Canida, partner.
In contrast, PanAgora Asset Management Inc., Boston, employs a yield-curve optimization strategy. While staying neutral against the risk of the Lehman Government/Credit benchmark (formerly known as the Government/Corporate index), PanAgora officials switch regimes depending on how their model forecasts Fed policy will go, explained Perry Vieth, director of fixed income.
The result: PanAgora, which runs more than $1 billion in the strategy, was ranked at 15%, second only to GW Capital's value bond management strategy for the year, and top-ranked for the three-year period, with a 9% annualized return.
Looking at PIPER's total fixed-income managed account universe, managers prospered by investing in a variety of strategies. For the fourth quarter, Brinson Partner's U.S. high-yield bond portfolio was top-ranked, returning 6.6%. After Brinson, GW Capital's value bond management strategy returned 3.5%, while Loomis, Sayles' medium-grade bond strategy returned 2.9%.
For the year, Zazove Associates LLC's high-yield convertibles program returned 22.8%; GW's value bond management came in second at 15.6%; and PanAgora's active core approach returned 15%.
In the PIPER commingled fund universe, Lipper & Co. LP's intermediate bond portfolio returned 5.9% in the fourth quarter, followed by Zazove's 3.8% return for its high-yield convertibles fund, and Loomis, Sayles' 3.1% for its fixed-income fund.
For the year, Zazove won top honors for the convertibles fund, returning 25.1%, while Amarillo National Bank's EB intermediate bond fund returned 13.4% and Northern Trust Global Investments' monthly long-term corporate bond fund returned 12.5%.