Special Report: Top-performing fixed income managers

Long-duration and government bond managers led fixed-income performance in the Morningstar Inc. Separate Account/Commingled Fund Database for the year ended March 31, reaping a premium for safety.

“Money managers that have concentrated on security — and particularly long government-owned fixed income — have come to the top,” said Steve Deutsch, director of separate accounts/collective investment trusts, at Chicago-based Morningstar.

Long-government managers took five of the top 10 Morningstar performance slots for separate accounts in the March 31 rankings. High-yield managers, which had dominated the upper echelons of the performance charts throughout much of 2006 and 2007, were far off the mark during this most recent reporting year. That's testament to the damage that subprime turmoil has had on investor confidence and credit markets, Mr. Deutsch said.

“What's happened with subprime is that risk has just become radioactive,” Mr. Deutsch said. “People were not paying any premium for risk last year, and now there's plenty of premium if you take on risk. Unless there's a dramatic change in the market and a complete reversal in the risk appetite yet again, I'd be hesitant to say high-yield has a long-term positive outlook.”

TCW Group Inc., Los Angeles, was the top performer in the separate account overall fixed-income category with its long-government strategy, which returned 20.07% for the year. Western Asset Management Co., Pasadena, Calif., took second with its global sovereign intermediate-term bond strategy, which returned 17.53%.

Multisector managers nailed down the next two slots, with Baring Asset Management, Boston, returning 17.48% for its global aggregate strategy and PanAgora Asset Management Inc., Boston, returning 15.4% with a long/short strategy.

Rounding out the top five was Income Research and Management, Boston, whose intermediate government Treasury inflation-protected securities strategy returned 14.9% for the year.

The next four slots went to long-duration government managers, with the following returns for the year: Pacific Investment Management Co., Newport Beach, Calif., 14.7%; Reams Asset Management Co., Columbus, Ind., 14%; Hoisington Investment Management Co., Austin, Texas, at 13.9%, and Jennison Associates LLC, New York, at 13.7%. Prudential Retirement's intermediate strategy took 10th place, with a return of 12.6% for the year.

The median return was 6.48% for the year, while the Lehman Brothers U.S. Government/Credit Bond index returned 8.36%.

TCW reaped rewards by being positioned for a “flight to quality,” said Jeffrey Gundlach, chief investment officer and chairman of TCW's multistrategy fixed-income committee.

“There are times where the strategy is set up to take credit risks and there are times when the strategy is avoiding credit risks in an aggressive way, and that's what we did going into 2007,” Mr. Gundlach said.

He said it was easy to underweight credit last year because the spread — the extra yield that the market was offering for taking extra risk — was at rock bottom.

“Going into 2007, it was blatantly obvious that credit risk was going to be a problem,” Mr. Gundlach said. “We had nothing but agency credit and government credit.”

“When things started to unravel in the middle part of 2007, what you saw was the Fed start to aggressively cut interest rates, and government bond yields and agency note yields and agency guaranteed mortgage-backed security yields fell dramatically while yields on credit risk securities like high-yield bonds went up,” Mr. Gundlach said. “The best idea for 2007 was: Avoid credit risk.”

Baring Asset Management beat most of the pack in part because it's a global manager and had an underweighted exposure to the U.S. dollar, said Alan Wilde, head of fixed income and currency.

“One of the reasons the absolute return is as high as it is obviously is that the dollar depreciation has meant that investments outside the dollar universe have performed very well,” Mr. Wilde said. Cross-market currency positions also reaped rewards for the fund — as did the fund's market selection, Mr. Wilde said.

“We've had an overweight position to the U.S. bond market for most of the last 12 months,” Mr. Wilde said. “We've had a short position in Japanese bonds, which again in a global context has meant that we have been able to use that budget to invest in other markets that have produced higher returns,” he added.

“We've had no exposure to anything that would be loosely related to subprime, and that's been a big savior.”

PanAgora, which ranked fourth, made good long/short bets against the yield curve throughout the year using eurodollar and Treasury futures, said Edgar Peters, chief investment officer of macro strategies.

“We were betting for a steepening for much of the period in the yield curve, and since there was a good amount of steepening, it fit right in with the portfolio,” said Mr. Peters. “It (the PanAgora quantitative model) called the direction of the yield curve correct more often than not last year, whether it was steepening or flattening, and that was essentially it.”

Both TCW and Baring are tweaking their strategies going forward.

“We've already moved 40% of strategic mortgage-backed into credit,” said TCW's Mr. Gundlach, noting that securities trading at 100 a year ago were trading at 60 during the first quarter. “That's called a major repricing. We're a best-ideas, actively managed fund and we're not just going to sit in "no credit risk' forever,” he said.

Added Mr. Wilde: “We're stepping back up to the plate in terms of adding investment-grade credit, and this is the first time we've done that in about three years.”

Mr. Wilde also said he believes the U.S. dollar might have reached a base and that his firm may be able to make money by increasing its dollar exposure. “The Fed's decision (April 30) to cut by a quarter and sending a signal that they wanted to wait before they did anything else may well mark a turning point for the low of the dollar, at least in the short term,” he said.

Though high-yield returns lagged during the most recent year, high-yield managers won nine of the 10 top slots in the five-year returns in this quarter's data.

The top five managers were: Penn Capital Management Co. Inc., Cherry Hill, N.J., 12.22%; DDJ Capital Management LLC, Waltham, Mass., 11.66%; Reams Asset Management, 11.24%; Loomis, Sayles & Co. LLP, Boston, 11.14%, and Delaware Investments, Philadelphia, 10.79%. All returns for periods of more than one year are compound annualized. The median was 4.7% for the five years; the Lehman Brothers U.S. Government/Credit Bond index returned 4.62% for the five years.

Reams Asset Management was the top high-yield performer for the year ended March 31, returning 3.54%. The median return for a high-yield manager was -2.35%, according to the Morningstar report.

In the separate account world bond category, FX Concepts Inc., New York, returned 48.1% for the year for its global portfolio. Strategic Fixed Income LLC, Arlington, Va., returned 26.48% for its global ex-Japan strategy. The international unhedged bond strategy of Rogge Global Partners, Westport, Conn., returned 23.38%, while the international unhedged portfolio of Mondrian Investment Partners Ltd., London, returned 23.19% and the international unhedged portfolio of Fischer Francis Trees & Watts Inc., New York, returned 22.34%.

The median world bond in the Morningstar database earned 11.42% for the year, and the Citigroup non-U.S. World Government Bond index returned 22.31%.

Long- and intermediate-term bond managers led the pack among commingled funds for the year, with TCW topping the list with 21.88% for the year. BlackRock Inc., New York, took second with a short-term strategy at 14.32%. Mellon Capital Management Corp., San Francisco, locked down the third slot with an intermediate-term strategy at 13.96%. Barclays Global Investors, San Francisco, managed the next two long-term strategies: a Treasury bond index portfolio that returned 13.63% and a long government bond index portfolio that returned 12.82%. The median commingled trust returned 7.24% for the year.

Contact Doug Halonen at [email protected]