Improved corporate profits translate into better bond returns

Some high-yield and convertible bond managers continued to reap strong returns in the first quarter, helped by the improving corporate profit picture, according to PIPER.

Zazove Associates LLC's High Yield Convertible Securities strategy returned 8.6% for separate accounts and 9.2% for commingled accounts, which put Zazove in first place for commingled accounts and second for separate accounts, behind New York-based Ryan Labs Inc.'s NDT Enhanced strategy, which returned 8.76%. For the one-year period ended March 31, Incline Village, Nev.-based Zazove led all bond managers in both the separate account and commingled categories as its high-yield convertible strategy returned 67.4% for separate accounts and 66.6% for commingled accounts, according to PIPER, the manager performance database owned by Pensions & Investments.

"Over the last year, what we saw was an extraordinary rally in credit and an extraordinary narrowing of credit spreads vs. where we exited in 2002," said Christopher Cook, Zazove Associates' San Francisco-based high-yield convertible portfolio manager.

"A few things that happened to enable that credit rally to occur were that capital markets opened back up for lower-quality credits and for the most part, the (earnings) numbers that companies are reporting are reliable — people and corporations are doing the right things and are trying to be more conservative and manage their businesses for long-term shareholders," he added.

Mr. Cook said his portfolio is well-diversified across industries but he noted that on a sector basis, independent power, technology and telecommunications led the pack. "Across the board it was a fairly systematic rally in all our positions and in credit in general," he said. "Over the last year we weren't out of kilter with most other managers' exposure either on a name-by-name or industry basis."

The Citigroup Broad Investment Grade bond index recorded a 2.7% return for the first quarter and a 5.5% return for the 12-month period. The median first-quarter return overall for fixed-income separate accounts was 2.5%, according to PIPER. For the year, the median was 5.5%.

Among separate accounts for the 12 months ended March 31, the Zazove portfolio was followed by GEM Capital Management Inc.'s Convertible Securities strategy, which returned 36% for the year; Nicholas-Applegate Capital Management's U.S. Convertibles portfolio, 34.8%; and Capital Guardian Trust Co.'s U.S. Convertibles strategy, 34.6%.

GEM's portfolio returned 3.1% in the first quarter while the Nicholas-Applegate convertible strategy returned 4.7% and Capital Guardian's approach, 1.8%.

Gerald Untermann, convertible securities portfolio manager at New York-based GEM Capital, said the asset class has had one of the best risk-reward characteristics in the fixed-income universe, with above-average yields and strong equity components.

"We look for companies first," he said. "The primary driver is finding companies whose fundamentals are compelling and whose stock prices are undervalued. Secondly, whether the convertible security is priced right." His focus is on midcap and large-cap names where the liquidity is high.

He said convertibles he continues to hold include energy company TXU Corp.; cable television operator Cablevision Systems Corp., which Mr. Untermann called "a very asset-rich company" although a stock "everyone loves to hate"; and Nextel Communications Inc., the wireless communications company.

Justin Kass, a portfolio manager on the U.S. high yield and convertibles team at Nicholas-Applegate in San Diego, said he also likes the wireless industry as well as select Internet stocks such as search engine companies Ask Jeeves Inc. and Yahoo! Inc. "They've been out of favor for a long time but they've got their cost structures down," he said.

Doug Forsyth, the lead portfolio manager of the Nicholas-Applegate convertibles strategy, said the key for the portfolio has been a comeback in total return. He said the approach works to capture 80% of the underlying stock's upside but only 50% of any downside. In addition, the current rising interest rate environment has helped.

"The best thing about total return convertibles is it's inversely correlated to interest rates," Mr. Forsyth said. "Rising interest rates that are typical during a period of stronger corporate profits is certainly what we've seen over the last year and last quarter. Stocks are going up and convertibles are going to perform right along with that."

In the commingled category, Boston-based Loomis, Sayles & Co. LP's High Yield Fixed fund, was second with 37.7% for the year, while Putnam Investments LLC's High Yield Management fund earned 27.2% and Loomis Sayles' Medium Grade fund, returned 25.1%.

The median first-quarter return overall for fixed-income commingled accounts was 2.6%, according to PIPER. The median return for the year was 5.6%.

Daniel Fuss, portfolio manager of both Loomis Sayles funds, said the corporate credit trends — cash flow relative to amount of debt and profitability — are the best he has seen in 40 years, which is likely to drive demand into corporate debt issues.

"As awareness of that spreads, people will be more inclined to buy corporates," he said. "And Treasury yields are still low historically, so people are pushing for more yield, causing them to go into corporates."

He added that while the improving corporate credit environment will mean declining yields — but rising prices — "that'll only help you to a point." If the entire bond market declines, corporates will be hit to some degree as well.

"We're in a rising rate environment and my guess is that at some point the Fed is going to let short rates go up," he said, estimating the 10-year Treasury bond yield will peak around 5.25%, 75 basis points up from its current level.

He said rising yields are making it easier for him because reinvestment risk is declining.

"To the degree yields go higher, more and more previously issued bonds start selling at discounts and the deeper the discount, the less reinvestment risk," he said. He added, however, that reinvestment risk needs to be managed along with market risk, which is more a factor in the medium-grade fund than in the high-yield fund.

Stephen Peacher, chief investment officer for high yield at Boston's Putnam Investments, agreed that the rising interest rate environment will have an impact on high-yield bonds. In fact, the question he is wrestling with is how great that impact will be.

"We think the high-yield market goes in its own cycle. It's got its own dynamic but it is influenced by the economy and interest rates," he said. "If the Fed raises more aggressively than expected, bonds will be hit hard and high yield won't be immune to that. The question is how is high yield going to perform if the Fed raises rates."

He has not yet come up with an answer, but said: "We're probably in for nice, competitive returns vs. other alternatives in fixed income."

Naperville, Ill.-based Calamos Investments' Growth & Income fund, which was among the top 10 performers in the overall separate account category with a one-year return of 32.2%, uses both high-yield and convertible bonds. Nick Calamos, senior executive vice president, head of investments and chief investment officer, said high yield has been helped by a "tremendous" amount of new issues.

"As rates go up, as everybody is expecting, the place to be is equity enhanced," he added. "The markets overall are pretty reasonably valued here, with a sustained recovery but not a great recovery somewhat built in. We think there's some room to run if we're in an environment of rising rates," he said.

For the five-year period in separate accounts, convertible bond funds again led the pack, with an 18.2% return for the Zazove high-yield convertible strategy, an 18.1% return for Los Angeles, Calif.-based Oaktree Capital Management LLC's high income convertible securities portfolio and 16.1% for the Calamos growth and income strategy.

In the commingled universe, Loomis Sayles led the group for the five-year period, with 11.4% for its investment-grade fund and 10.3% for its medium-grade fund. The Privest fund of Prudential Private Placement Investors, Newark, N.J., returned 9.6% for the period.

The median five-year return for the commingled universe was 7.3%, matching the five-year return of the Citigroup benchmark. The median for the separate account universe was 7.2%.