Most domestic fixed-income portfolios generated positive returns in the second quarter, according to the Pensions & Investments Performance Evaluation Report, but long-duration domestic portfolios led the charge, bolstered by a weak U.S. stock market and declining interest rates.
The high-yield sector was the exception, with a -3.2% median quarterly return and a zero median for the 12 months ended June 30.
Six of the top 10 overall PIPER managed fixed-income accounts were either long or "extra-long" duration portfolios in the second quarter. Bridgewater Associates Inc., Westport, Conn., generated a return of 13.4%; S E B Asset Management America Inc., Stamford, Conn., returned 7.4%; Jennison Associates LLC, New York, returned 6.4%; Hoisington Investment Management Co., Austin, Texas, 6.2%; State Street Research & Management Co., Boston, 5.8%; and Denver Investment Advisors LLC, Denver, 5.5%. The Salomon Broad Investment Grade Bond index returned 3.5% in the quarter.
The top three PIPER commingled fixed-income funds were passively managed long-duration funds, including two indexed bond funds from Barclays Global Investors NA, San Francisco: the BGI Long Government Bond Index Fund, which gained 6.2%, and the BGI 20+ Treasury Bond Index Fund, up 6.1%. The Monthly Long Term Government Bond Fund managed by Northern Trust Global Investments, Chicago, also gained 6.1% in the second quarter. Northern's passively managed Monthly Intermediate Government Bond Fund also finished in the top decile with a return of 5.1% in the second quarter.
Bridgewater's managed extra-long duration bond account return earned it the top spot in the PIPER overall fixed-income and long-duration categories for the quarter and for the 12 months ended June 30. The Bridgewater core-plus fund claimed the top spot in the PIPER broad market fixed-income category, returning 6.5% in the quarter.
William P. Mahoney, business development director at Bridgewater, said the extra-long fund's duration is linked to that of the 25-year U.S. Treasury zero coupon bond. He said Bridgewater adds value by shifting the duration and by using inflation linked, global and nominal bonds as appropriate.
Lacy Hunt, chief economist at Hoisington, said structural problems in the U.S. economy make the case for continued reliance on long-duration bonds. "Consumers are overextended, the corporate sector is overleveraged with excess capacity and no pricing power and the overdependence of the rest of the world on the U.S. economy. We doubt that monetary policy can be effective in that environment. Another concern we have is the continuing high valuations in the U.S. stock market," said Mr. Hunt.
As a result, the Hoisington portfolio has nearly 66% of the portfolio in Treasury bonds maturing between 2025 and 2029 with the balance in zero-coupon Treasuries maturing between 2021 and 2027.
"When we think the multiyear inflation trend is down we are invested in Treasury bonds and principal
Mr. Hunt said there is less risk in Treasury instruments than in the Standard & Poor's 500 stock index, noting Hoisington's portfolio is up 10.1% for the last 15 years, compared with the S&P, which is up 10.9% for the same period.
That the best performing fixed-income funds in the overall PIPER commingled fund universe are passively managed is significant, said Pete Wilson, managing director and head of U.S. fixed income at BGI.
"It's been a tough market for active managers," he said. "Credit risks have punished them, rather than rewarding them." He said active managers who owned WorldCom Inc., Enron Corp., or debt in much of the telecommunications industry generally underperformed the market.
Mr. Wilson said BGI'S two commingled bond funds were helped by the firm's successful securities lending program, which allowed it to "not only match but to beat the benchmark index." (For the BGI long government fund, the benchmark is the Lehman Brothers Long Government Bond Index; for the BGI 20+ fund, the benchmark is the Lehman Brothers 20 Year Treasury Bond Index) He said securities lending added between five and 10 basis points to the performance of each of the two funds.
The two funds are made up mostly of U.S. Treasury and agency instruments, which are "very sought after" in the securities lending market, said Mr. Wilson. That enables BGI to generate low risk "extra income" in addition to the already reduced cost of passively managed funds.
Judy Bednar, senior vice president and head of the quantitative management group at Northern Trust Global Investments, said the Northern funds are "focused funds" which closely track their benchmarks. (For the long-term fund, the benchmark is the Lehman Long Term Government Bond Index; for the intermediate fund, the benchmark is the Lehman Intermediate Government Bond Index.) "The fact is that they are sector funds that don't hold corporates; credit exposure didn't help during this period," she said. "If you didn't hold corporates, you probably did very well."
For most fixed-income portfolios, another key to positive returns was high-quality holdings. "One reason we did so well was that this is a very high-quality portfolio," said William Nemerever, head of the fixed-income group at Grantham, Mayo, Van Otterloo & Co., Boston, whose GMO commingled domestic bond fund finished in the top decile for the quarter overall and third in the PIPER commingled funds broad market fixed-income category with a return of 4.7%.
He said the fund is composed primarily of AA and AAA government bonds and government agency securities and asset-backed securities with only a small allocation to corporate bonds. In addition, he said, the portfolio's duration "was a little longer than the typical market fund" at about 5.25 years.
"We had the benefit of declining rates," he said. "in addition to owning less liquid but very high quality securities."
The Amarillo National Bank's EB intermediate bond fund turned in some of the most consistent across-the-board fixed-income performance results for several periods. The Amarillo, Texas-based Bank's EB fund finished the second quarter in the top decile for PIPER overall commingled fixed-income funds with a return of 4.6%. In addition, the Amarillo National Bank fund finished second among PIPER intermediate-duration funds for the quarter and in the top spot for the one-, three- and five-year periods ended June 30.
"One of the biggest things we have done is to utilize spread paper to achieve a higher yield, and we have been able to avoid some of the blowups like WorldCom," said Brian Wood, portfolio manager at Amarillo National Bank.
"We don't own any Treasuries," said Mr. Wood. "We think the Treasury market is overdone. The account has a high concentration in agencies, asset-backed securities and corporate bonds."
Mr. Wood said with Treasury market yields at "40-year lows" the federal government "may have to issue more paper" in a slow economy and become "net borrowers again."
"We've been more negative on Treasuries in this market believing that spreads will tighten as the government starts borrowing again," he said.
The Bond Market Association's Economic Advisory Committee in July forecast an increase in both short- and long-term interest rates over the next five quarters.
According to the committee, the yield on the 10-year Treasury note is expected to rise by about one percentage point to 5.65% by next September, while the Federal Funds rate is expected to rise to nearly 3% from 1.75% currently. The committee said inflation should remain in check through next year.