Credit crunch makes fixed-income manager changes tricky

Pension funds looking to switch bond managers this year might find their new firms' ability to unload chunks of their portfolios, from structured products to lower-rated paper, hamstrung by the market's unprecedented liquidity drought.

One example: the Illinois Teachers' Retirement System, Springfield, is reporting slow progress in shedding parts of a $1 billion bond portfolio that had been managed by Western Asset Management Co., Pasadena, Calif. The $41.7 billion fund — which terminated WAMCO in January — tapped Pacific Investment Management Co., Newport Beach, Calif., last month to prune riskier assets from the portfolio.

At a Feb. 21 board meeting, Scottie Bevill, senior fixed-income investment officer for the pension fund, said the huge amount of repricing going on now for big segments of the fixed-income market has left portfolio managers at PIMCO unable to make major changes to the portfolio.

Spokeswoman Eva Goltermann said Illinois Teachers' trustees will decide in May which of three existing enhanced U.S. equity managers — PIMCO; Barclays Global Investors, San Francisco; and T. Rowe Price Associates Inc., Baltimore — will get the mandate on a permanent basis. For now, the fund is looking to PIMCO to trim portfolio holdings that are further out on the risk spectrum.

Investment consultants say the Illinois Teachers fund isn't alone. Many institutional investors “can't move their (fixed-income) portfolios,” and anyone who thinks the answer to their problems now is to switch managers could be in for a “rude shock,” said Cynthia Steer, chief research strategist with investment consultant RogersCasey LLC, Darien, Conn.

February was a “disastrous month” for fixed income, Ms. Steer said. With sectors such as asset-backed securities suffering through their worst liquidity drought in memory, clients might find they won't be able to move portfolios exposed to those sectors at an acceptable cost for the next year or two, she predicted.

The seize-up in the bond market could make such adjustments a problem for clients, who might be feeling particular pressure to shuffle managers because their fixed-income portfolios have failed to offset sagging equity prices during the current bout of market volatility.

A sales executive with a major bond manager, who declined to be named, noted that many fixed-income managers have turned out to be more closely correlated to clients' equity managers than anticipated.

Consultants say sitting tight might be the better option for now. Those terminating a manager today could find themselves “trying to sell bonds at the worst time,” noted one, who declined to be named.

Industry veterans say the market has seen other periods — such as 2002 and 1998 — where liquidity dried up dramatically, but this time around the pain is lasting longer. In previous episodes, the worst was usually over in a matter of months, said Marko Komarynsky, the Chicago-based head of fixed-income manager research with Watson Wyatt Investment Consulting Inc.

“Since July or August, the fixed-income market has been broken, by and large,” with banks and dealers stung by billions of dollars of recent losses on their holdings unwilling to make markets in those securities, said Nicholas Bonn, executive vice president, State Street Global Markets, Boston, who heads the firm's transition management business.

Mr. Bonn said State Street employees are working overtime to do “buy side to buy side” placements. While intermediaries, such as dealers, remain crucial, State Street “has been able to place a good chunk of our transitions with natural buyers of these securities,” he said.

Mr. Komarynsky said every time the market seems to be calming down there's been another unsettling surprise, and it could be anywhere between two and six quarters before the market normalizes.

Michael W. Roberge, chief investment officer for MFS Investment Management, Boston, agreed. When sentiment turns, there could be a flood of money returning to the market, but whether that happens in one month, or 12 or 18, is anybody's guess, he said.

The rise of structured products has aggravated the fallout from the current liquidity drought. Paul Sachs, a Philadelphia-based consultant on transition management with Mercer LLC's Sentinel Group, said the synthetic structures that have become commonplace in core-plus and other portfolios “can be very difficult to unwind. ... Frequently you've got to go back to your counterparty,” which might prove unwilling to unwind the arrangement without imposing breakage fees, he said.

RogersCasey's Ms. Steer said a growing number of investors could find themselves holding hard-to-sell securities for a while, and should begin to prepare their boards for a potentially uncomfortable ride over the next few years.

In a December paper billed as a “survival kit for CIOs,” Ms. Steer said the portion of a client's core and core-plus holdings facing valuation issues, whether short-term or long-term, could be between 15% and 45% of the bond portfolio.

Funds exposed to the hardest hit sectors, such as structured investment vehicles, should prepare their boards for potential write-downs, Ms. Steer wrote. For the healthy portion of client portfolios, she called for further diversifying holdings with allocations to emerging markets debt and infrastructure.