Rising interest rates and signs of a pickup in the economy hurt fixed-income returns in the quarter ended March 31. But the Pensions & Investments' Performance Evaluation Report shows that an eclectic group of fixed-income funds, including high yield and stable value, turned in the best performance for the quarter.
While the median fund in the PIPER managed accounts fixed-income universe had a return of zero, down from 0.17% the previous quarter, the Salomon Broad Bond index returned 0.1% for the first quarter. The best-performing managed fixed-income fund was the high-yield convertibles fund of Zazove Associates LLC, Incline Village, Nev., with a return of 3.2%. Zazove was in fifth place for the year and three years ended March 31.
Christopher Cook, portfolio manager at Zazove, said the fund buys "busted convertibles," which are convertible bonds whose prices fall dramatically in tandem with the stock prices of the company.
The secret to this system, said Mr. Cook, is to "buy decent credits with outstanding return characteristics. We are buying convertibles of companies that are not in bankruptcy, and the majority of them are not going to need to restructure. We find companies with good cash flow and asset value, where the stock price and the bond price have gone down."
He said the busted convertibles market is very inefficient and the fund can get returns of 10% to 25%.
The intermediate bond fund of First Pacific Advisors, Los Angeles, came in second for the quarter with 3.1%; it was in second for the year with 10% and third for the three years with 9.4%. The fund buys a variety of fixed-income instruments, including busted convertibles, according to Robert Rodriguez, chief executive officer.
During the first quarter, he said the fund had 75% of its assets in government, agency and investment-grade corporate bonds and 25% in broken high-yield convertibles. The firm has been able to "outperform in a rising interest-rate environment, have flat performance in a steady interest-rate environment and underperform in a falling interest-rate period."
"We would prefer to deploy our capital when there is fear and pessimism in the debt markets, with rising interest rates," he added. Mr. Rodriguez said he thinks high yield was one of the most attractive areas to be in over the last year.
"There are two groups of high-yield managers: those who owned telecom (bonds) and those who didn't," he said. "Those who didn't had good performance."
In fact, some very high returns for the quarter were those of high-yield bonds in a combined managed and commingled universe. MacKay-Shields LLC, New York, came in first with a return of 3.7% for the quarter, compared with the Salomon High-Yield index, which returned 2.0% for the quarter, the best return of any fixed-income benchmark. Oaktree Capital Management LLC, Los Angeles, came in second, returning 3.4% for the quarter. New York-based Muzinich & Co.'s Muzinich high-yield fund and America Yield fund were in third and fourth place, respectively, with returns of 3.3% and 3.2%.
George Muzinich, CEO, pointed out that when the economy appears to be on the upswing, higher-rated high-yield bonds tend to perform well. He added that it's best to have a broadly diversified portfolio.
"We don't make sector bets," he said. "We tend to run a well-diversified portfolio, sticking to better quality names in the upper tier of the high-yield universe," he said.
Mr. Muzinich added that his funds "managed to stay out of harm's way, with no telecom or media bonds, which were disappointing."
He also said that with the unfolding Enron Corp. scandal and concern over corporate debt loads, "people wanted to be more careful. The upper tier of the high-yield universe tends to do better all the time, especially when the economy starts to recover."
For broad market fixed-income accounts in the managed accounts universe, GW Capital, Bellevue, Wash., was in first place for the quarter with a value portfolio that returned 1.5%. Hartford, Conn.-based Phoenix Investment Counsel's core-plus strategy returned 0.9%, and Wellington Management, Boston, was in third place for the quarter with its core-plus portfolio, which returned 0.8%.
In the commingled accounts universe, the intermediate portfolio of Lipper & Co. LP, New York, came in first for the quarter with 1.9%. In second place was Norwest Bank, Minneapolis, whose stable return fund returned 1.5%; and in third place was Morley Financial Services Inc., Oswego, Ore., with a stable value fund returning 1.4%.
John Caswell, managing partner at Norwest, said the stable value portfolios performed so well at least partly because the securities use book-value accounting, not mark-to-market accounting like other types of fixed-income instruments. "Stable value funds will have a fairly steady positive return quarter-in and quarter-out," he said. "When rates went up 50 or 60 basis points in the quarter, stable value funds didn't have the price depreciation of most bond portfolios because it is not marked to market."
Steve Ferber, senior vice president at Morley, said, "We run a conservative, high-quality fund, even relative to our peer group." He said that securities in the fund have an average credit quality of AAA.
At the other end of the performance spectrum, international bond funds turned in the worst performance for the quarter. Boston-based Grantham Mayo van Otterloo's GMO currency-hedged international bond fund had the best performance in the category with a -0.01% return. Bridgewater Associates, Westport, Conn., came in second with a return of -0.1% for its non-U.S. hedged portfolio. In comparison, the Salomon Non-U.S. World Government Bond index returned -1.9%.
William Nemerever, co-head of fixed-income at GMO, said, "Rising interest rates around the globe hit these funds more than anything else." He added that because the U.S. dollar was a bit stronger during the quarter than other currencies, currency-hedged funds performed better than other international bond funds.