Fixed income: Convertible strategies win quarter, but high-yield takes annual honors

As equity markets continued their climb in the fourth quarter, convertible bond managers flourished, brushing aside their high-yield peers to dominate the fixed-income managed-account universe and leading the commingled fund universe of PIPER, a manager performance database owned by Pensions & Investments.

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For the year, however, high-yield strategies were still in charge. Seventeen of the year's top 25 managed fixed-income accounts belonged to high-yield managers — and each of those posted returns of more than 25%, according to PIPER. At the very top of the overall bond charts, Zazove Associates' High Yield Convertibles Program, a separately managed account, gained an amazing 72.5% in 2003.

But in the fourth quarter, even the best performers struggled to crack double digits.

Only four strategies in PIPER's managed accounts bond universe gained more than 10% last quarter. The U.S. convertibles strategy run by Capital Guardian Trust Co., Los Angeles, the quarter's best-performing fixed-income separate account, earned just less than 13% in the period. Zazove's high-flying high-yield convertibles program returned 9% for the period, according to PIPER.

The Citigroup Broad Investment Grade bond index posted 0.4% for the quarter and 4.2% for the year; the median PIPER bond return for both managed accounts and commingled funds was 0.4% for the quarter and 4.4% for the year.

High-yield strategies did well in the first half of 2003, before equity markets improved, because of tightening credit spreads, said Justin Kass, a portfolio manager on the U.S. high yield and convertibles team of Nicholas-Applegate Capital Management, San Diego. Once the markets came back, he said, "companies started reporting good numbers, and that helped convertibles."

Nicholas-Applegate's U.S. Convertibles strategy ranked second in the managed accounts universe for the quarter, returning 10.7%, and ranked 15th for the year, with 28.8%, according to PIPER. The strategy benefited from telecommunications and technology companies, Mr. Kass said, as well as those in the "basic materials" sector, including United States Steel Corp. and Arch Coal Inc. But "every single sector is recovering," he added.

Convertibles managers started 2003 on the trail of the "junkiest" securities, and did well when those delivered "stratospheric returns in the first three quarters," said Christopher J. Towle, partner and director of high yield and convertible investments at Lord, Abbett & Co., Jersey City, N.J. In the fourth quarter, the emphasis was more on stock selection, and this change in approach contributed to the drastically lower returns reported in the last quarter, Mr. Towle said.

Lord, Abbett's convertibles portfolio was overweight in cyclical industries, semiconductor equipment makers and generic drug companies, Mr. Towle said. Among its "junkier" holdings were Lucent Technologies Inc., Nortel Networks Ltd. and Charter Communications Inc., he said. The portfolio returned 9.9% in the fourth quarter, ranking fifth overall among managed bond accounts. For the year, it returned 25%, placing it in the top decile, according to PIPER.

The other two managed accounts in the quarter's top five were the convertibles strategy managed by TCW Group Inc., Los Angeles, which earned 10.2%; and the Calamos Growth and Income strategy, run Calamos Asset Management Inc., Naperville, Ill., which returned 10.2%, according to PIPER.

In the commingled fund universe, the top five strategies for the quarter were the Zazove Convertible Securities Fund, run by Zazove Associates LLC, Incline Village, Nev., which earned 12.9%; the high-yield fund managed by Loomis, Sayles & Co. LP, Boston, 11.2%; Zazove's high-yield convertibles fund, 10.9%; the EB Convertible Securities fund, run by Victory Capital Management Inc., Cleveland, 7.5%; and the high-yield fixed income strategy of General Motors Asset Management, New York, which earned just less than 7%.

For the year, the leading managed accounts after Zazove's high yield convertibles strategy were the core-opportunistic high yield strategy run by Penn Capital Management Co. Inc., Cherry Hill, N.J., which earned 42%; the high income convertible security strategy of Oaktree Capital Management LLC, Los Angeles, 36.8%; Loomis, Sayles' high yield full discretion portfolio, 36.4%; and Capital Guardian's U.S convertibles strategy, which earned 35.8%, according to PIPER.

In the commingled funds universe for the year, Zazove was again on top. Its high-yield convertibles fund earned 70.4%, and its convertibles security fund gained 59.7%. The other three funds in the top five were the Loomis, Sayles high-yield fixed-income fund, earning 48%; the high yield strategy run by Putnam Investments LLC, Boston, 32.1%; and Loomis, Sayles' fixed-income fund, with 30.2%.

Lord, Abbett's Mr. Towle said 2004 is "going to be a good year for convertibles." Interest rates "will behave themselves," or rise only slightly, he said, and returns on convertible products will compete with the Standard & Poor's 500 stock index.

Mr. Kass of Nicholas-Applegate also expects convertibles to continue delivering equity-like returns, one of the features of an asset class that also promises less risk.

In high yield, a 7% to 10% return over the next four years would be "phenomenal," said Christian M. Noyes, senior vice president and principal at Penn Capital. He said 20% to 40% of fixed-income allocations should be in high yield, to protect against rising interest rates. In that environment, "high yield will outperform high grade any day of the week," he said.

The same familiar names showed up at the top of PIPER's three- and five-year overall fixed-income rankings. In the No. 1 and No. 2 spots of the managed-account charts for both periods were Zazove's High Yield Convertibles Program, which gained a compound annualized 28.5% for the three years and 17.5% for the five years, and Oaktree Capital's High Income Convertible Securities strategy, which had a three-year return of 21.4% and a five-year return of 16.2%.

For commingled funds, Zazove Associates was once again the leader. Its High Yield Convertibles Fund led the three-year period, returning 28.8%, and its Convertibles Security Fund came in second for the period, earning 16.2%. Its Convertibles Security Fund was the top five-year performer, gaining 16.7%, according to PIPER. The second-place five-year performer was the Nationwide Provident Fixed Income Fund, returning 11.5%.

The median managed account in the overall PIPER fixed-income universe earned 7.5% for the three-year period ended Dec. 31, and 6.6% for the five-year period. The median commingled fund returned 7.7% for the three years and 6.7% for the five years, according to PIPER.

The Citigroup Broad Investment Grade index posted a three-year return of 7.6% and a five-year return of 6.6%.