Fixed income: High-yield bonds return to forefront, a "huge departure' from strategies of past year

High-yield bond strategies mostly dethroned long-term bond strategies for the year ended Sept. 30, according to the best performing fixed-income managers' rankings in the Morningstar Inc. separate account/collective investment trust database.

The entire top 10 for one-year returns is new, led by six high-yield strategies and two ultrashort bond portfolios. The entire top 10 was long bond portfolios the previous quarter with most of them holdovers from the first quarter. Long bond strategies still take up nine of 10 spots on the rankings for five-year returns.

“This is a huge departure from the trends seen (over the past year) when the top 10 was predominantly made up of long duration strategies,” said Diana Scott, product development manager, separate accounts, at Morningstar, Chicago. “The important story to see is high-yield strategies emerging pretty prominently this quarter.”

The main reasons for the change in strategies are an increased confidence in the bond market and investors' propensity to take on more risk, Ms. Scott said. In the third quarter, the Federal Reserve announced it will keep interest rates low into 2015 while European leaders showed more solidarity and commitment to the eurozone.

“All these issues came to play to create a more comfortable setting,” Ms. Scott said.

All broad fixed-income classes had a positive median return for the quarter ended Sept. 30 with a tightened spread between the highest and lowest performers. For the quarter, the highest return in the universe was 15.13% and the lowest, -2.1%. For the quarter ended June 30, the highest was 17.14% and lowest, -8.61%.

For the year ended June 30, the median strategy among all domestic fixed-income separate account portfolios returned 7.19%. The Barclays Government/Credit index returned 5.7% in the period, while the Credit Suisse High Yield index returned 17.92%.

Emerging markets fixed-income strategies had the highest median returns for the year ended Sept. 30 at 20.07%, but those strategies are not included in Morningstar's rankings, which only address U.S. strategies. Other strong performers for the year include high yield, 18.33%; convertibles, 15.51%; and long duration, 12.28%.

“Investors took more risk and the risk paid off,” Ms. Scott said.

The top three performers for one-year returns all used an enhanced S&P 500 equity strategy with short duration underlying bonds attempting to outperform the LIBOR rate, which is the baseline financing rate on futures contracts for the strategies. The S&P 500 returned 30% for the year.

Western Asset Management Co.'s U.S. Index Plus ultrashort bond portfolio was No. 1 for the overall universe with a one-year net return of 35.52%. WAMCO holds a mix of bonds and equity futures; the futures are used to track the price fluctuations of the S&P index, Ms. Scott said.

Following WAMCO were TCW MetWest's AlphaTrak, which returned 33.33%, and Atlantic Asset Management LLC's Enhanced Stock Indexing portfolio, with 33.17%.

Morningstar categorizes the enhanced equity strategies as fixed income based on portfolio holdings. The top three managers' holdings are predominately fixed income with some usage of cash.

The TCW MetWest strategy also uses S&P 500 futures, which does not require cash upfront, and then manages ultrashort bonds to produce an alpha overlay.

“The objective is to produce good returns because of the S&P 500, but also outperform the S&P due to holdings of the fixed-income portfolio performing well,” said Stephen Kane, Los Angeles-based group managing director and generalist portfolio manager in the U.S. fixed income group at TCW Group Inc.

The bond holdings consist of 2004-2008 vintage non-agency mortgage-backed securities and other short duration fixed-income such as commercial mortgage- and asset-backed securities. A significant part of the returns has been floating-rate bonds of large banks that are trust preferred issues, Mr. Kane said. Banks are de-risking and buying back bonds at a significant premium to prices, which is creating another 50 basis points in returns, he added.

“From late fourth quarter to this year, the market has begun to realize increasingly that non-agency mortgages offer very good value ... high upside scenarios of mid-teens to 20s (percent) return.”

TCW's Opportunistic MBS, which invests purely in non-agency MBS, is ranked No. 6 for one-year returns at 23.8%.

Atlantic's enhanced portfolio uses a combination of futures and swaps and the underlying short-term bonds provide the excess return, said Elaine Hunt, Stamford, Conn.-based managing director and head of fixed-income investments. The strategy produced three percentage points of excess return over the S&P 500.

“Most equity managers drool for this kind of alpha,” Ms. Hunt said.

The portfolio currently uses an enhanced cash strategy with a short duration of less than half a year. It invests in investment-grade corporate bonds, mortgage-backed securities, asset-backed securities and some government exposure. In the last year, the equity portion has been made up of two-thirds futures and one-third swaps.

“It doesn't make sense to extend the duration with falling rates,” Ms. Hunt said. “There's a lot of downside if interest rates rise.”

Ms. Hunt said the portfolio is not subject to negative effects from a rising interest rate environment and has a “good portfolio yield cushion over LIBOR.”

Rounding out the top five for the year are Nomura Corporate Research and Asset Management Inc.'s High Yield Total Return Institutional portfolio, 25.08%, and First Trust Advisors LP's Taxable Closed-End Fund, a multisector bond strategy, at 24.13%. The portfolios ranked Nos. 6-10 are all high-yield strategies.

For the second straight quarter, CMG Capital Management Group Inc.'s System Research Treasury Bond Program was ranked No. 1 in five-year returns at 24.2%.

“The strategy looks at a number of fundamental factors to determine if interest rates are moving up or down,” said Steve Blumenthal, founder and CEO of the King of Prussia, Pa.-based CMG. “Then we take a position — long 30-year government bond exposure or short government bond exposure.”

Mr. Blumenthal said the strategy has little correlation to most government bond portfolios and uses a quantitative process attempting to catch inflationary trends without factoring in “fear trades,” which can occur in developments such as the ongoing European debt crisis.

Mr. Blumenthal is not confident in long Treasury bonds over the next two to three years and said the inflation risk is “significant.” In inflationary times, the strategy switches to inverse government bond exposure when certain triggers are met, such as underperforming fixed income, rising interest rates and commodity price pressures. The portfolio made seven short and long trades each in the last year.

“You need to be more tactical with fixed income or you will get clobbered when interest rates rise,” Mr. Blumenthal said.

The strategy has paid off for most of the past five years. In 2009, it returned 10% while the Barclays Long Term Treasury Index returned -13%. In 2012, the portfolio has outperformed the index 13.2% against 4.4%.

Following CMG in five-year returns is TCW's Securitized Opportunities strategy at 23.86%. The portfolio switched from less than 10% in non-agency MBS in early 2009 to 80% currently, Mr. Kane said. It also invests in agency MBS, CMBS and asset-backed securities.

Rounding out the top five are NISA Investment Advisors LLC's 15+ STRIPS portfolio, 15.07%; NISA's Long Duration Government Only Consolidated portfolio, 14.86%; and Delaware Investments' Long Duration Fixed Income strategy, 14.55%.

For the collective investment trust universe, the top one-year performers were Loomis, Sayles & Co.'s High Yield Conservative strategy at 20.87%, followed by Neuberger Berman Group LLC's High Yield Fund at 20.26%.

Rounding out the top five for the one-year commingled universe were: Brandywine Global Investment Management LLC's credit opportunity strategy, 20.15%; Loomis Sayles' Multi Sector Full Discretion, 20.11%; and J.P. Morgan High Yield Bond strategy, 18.86%.

For the 12 months ended June 30, the median overall domestic fixed-income return for collective investment trusts in Morningstar's data was 6.72%. n