Long-duration bond strategies remain on top in falling interest rate environment

Long-duration bond strategies continued to dominate Morningstar Inc.'s domestic fixed-income separate account/collective investment trust database, occupying eight of the top 10 spots for the year ended Sept. 30.

In the previous quarter's ranking, long-duration strategies occupied all top 10 spots for the 12 months ended June 30.

Falling interest rates continued to benefit long-duration strategies, said Emory Zink, fund analyst, fixed-income strategies, at Chicago-based Morningstar. The median return for broad long-duration strategies tracked by Morningstar was 14.98% for the 12 months ended Sept. 30, slightly above the Bloomberg Barclays U.S. Long Government/Credit Bond index at 14.66%.

Looking at other fixed-income sectors, the Bloomberg Barclays U.S. Municipal Bond index returned 5.58% for the year, “bolstered by strong fundamentals and robust demand,” Ms. Zink said, and the Bloomberg Barclays U.S. Corporate High-Yield Bond index returned 12.73%. The median return for Morningstar's overall domestic fixed-income universe was 5.42% for the year and domestic high-yield bonds, 10.37%.

While falling interest rates and tightening credit spreads helped put long-duration strategies on top for the year, the third quarter revealed some setbacks.

The Bloomberg Barclays Long U.S. Treasury index returned -0.36% in the quarter, which Ms. Zink attributed in part to investor anxiety over an expected Federal Reserve interest rate hike and the presidential election. During the same period, the Bloomberg Barclays Municipal Bond index returned -0.3%, its first negative quarterly return in more than a year, and the Barclays U.S. Corporate High-Yield index, “settling” from the energy stresses experienced in the first half of the year, returned 5.55%, Ms. Zink said.

TCW Group Inc.'s AlphaTrak strategy occupied the No. 1 spot on the one- and five-year rankings with gross returns of 20.31% and 18.25%, respectively. (Returns for all periods of more than one year are compound annualized.)

Although Morningstar classifies AlphaTrak as an ultrashort bond strategy, TCW's Stephen M. Kane said it is really an “enhanced equity indexing strategy.”

Portfolio managers aim to exceed the total return of the Standard & Poor's 500 index by investing in a combination of short-term bonds and S&P 500 index futures, said Mr. Kane, Los Angeles-based group managing director and generalist portfolio manager in the U.S. fixed-income group at TCW.

While the majority of the strategy's one- and five-year returns came from holding S&P 500 futures (the S&P 500 returned about 15.4% and 16.4%, in those periods, respectively), the fixed-income portion, which includes investment-grade corporate bonds, asset- and mortgage-backed securities, high-yield bonds and other non-Treasury securities, benefited from excess yield above that of the London interbank offered rate, tightening credit spreads and falling interest rates, Mr. Kane said.

Another TCW strategy — Opportunistic Mortgage-Backed Securities — ranked sixth on the five-year list with a gross return of 10.64%.

That strategy focuses on the non-agency mortgage-backed securities market, which over the past five years has been the best-performing fixed-income sector, Mr. Kane said.

Many of the loans that originated between 2004 and 2007 were poorer in quality and defaulted very quickly during the financial crisis. The falling prices on these loans created “tremendous return opportunities,” Mr. Kane said.

More recently, however, performance drivers have been “less about the market being oversold and cheap, and more about positive fundamentals,” Mr. Kane said.

The “worst borrowers that took out 2007/2008 loans defaulted very quickly” in 2009, 2010 and 2011, leaving a “significantly improving pool of borrowers,” Mr. Kane said. “And then, of course, the housing market has turned and the economy has grown and recovered.”

Combing through this pool of borrowers requires a large investment in technology and people, Mr. Kane added. On TCW's 65-member fixed-income investment team, about 30 individuals are focused on securitized products.

Coming in second behind TCW's AlphaTrak strategy on the one-year list was NISA Investment Advisors LLC's 15+ STRIPS strategy with a gross return of 19.21%. The strategy topped the rankings last quarter for the year ended June 30.

The strategy is a composite of zero-coupon Treasury bonds that mature in 15 years or longer, said Jess B. Yawitz, St. Louis-based CEO and chairman at NISA.

Given the inverse relationship between interest rates and bond prices, long-duration strategies in general did well over the past year, Mr. Yawitz said.

Many clients have selected the strategy to hedge the interest rate risk in pension liabilities, Mr. Yawitz added, further noting there's been “a pervasive concern” across corporate pension fund sponsors in managing the effects of changing interest rates on plans' funding ratios.

Rounding out the top five for the year ended Sept. 30 were Pacific Investment Management Co.'s Long-Term Bond — Long-Credit strategy with a gross rReams Asset Managementwed by Reams Asset Management Co.'s Long-Duration Fixed-Income at 17.4%; and First Trust Advisors LP's Taxable Closed-End fund, a multisector bond strategy, at 17.16%.

For the Reams strategy, a 3% position in metals Vale SA, Freeport-McMoRan Inc. and Teck Resources Ltd., collectively added almost 100 basis points to performance in the last year, said Todd C. Thompson, Columbus, Ind.-based senior portfolio manager. Metals were introduced to the portfolio in the autumn of 2015.

The strategy also benefited from a roughly 15% exposure to the energy sector with holdings like Apache Corp., Devon Energy Corp., Anadarko Petroleum Corp., Marathon Oil Corp., Petróleo Brasileiro SA and Petróleos Mexicanos collectively adding another 100 basis points to performance over the past year, Mr. Thompson said.

In general, long-duration strategies benefited from falling Treasury yields and tightening credit spreads over the year, Mr. Thompson said. In the 12 months ended Sept. 30, yields on 30-year U.S. Treasuries declined by a little more than 50 basis points and long-corporate credit spreads tightened by 33 basis points.

That being said, “this stellar performance brings risks on a prospective basis as we believe much of this rally had to do with income-seeking and risk-seeking as many people fear crowding out by central bank buying,” Mr. Thompson said, adding that the “stellar performance of corporates stands in contrast to demonstrable deterioration in fundamental credit conditions over the last several years including leverage and interest coverage.”

The five-year separate account ranking was dominated by high-yield bond strategies, which claimed eight of the top 10 spots and four of the top five spots.

Behind the leader TCW AlphaTrak, a carryover from last quarter's list, was Nomura Corporate Research and Asset Management Inc.'s High-Yield Total Return Institutional strategy with a gross return of 11.32%; Federated Investors Inc.'s Opportunistic High-Yield Composite, 11.28%; Oaktree Capital Management LP's EuropeDDJ Capital Management LLCnd DDJ Capital Management LLC's Total Return CreDDJ Capital Managementand DDJ Capital Management LLC's Total Return Credit Composite, 10.68%.

Overall, domestic fixed-income strategies returned a median 3.81% for the five years ended Sept. 30. High yield returned a median 8% over the five years.

In the domestic collective investment trust universe, long-duration strategies held eight of the top 10 spots for the year ended Sept. 30. High yield occupied the remaining two. State Street Global Advisors' U.S. Long-Credit Bond Index was first with a net return of 16.21%, followed by J.P. Morgan Asset Management's Long-Credit fund, 15.97%; BNY Mellon's EB LT Credit Bond Index, 15.69%; JPMAM's High-Quality Long-Corporate, 15.53% and JPMAM's Long-Duration Credit, 15.21%.

The one-year median return for CITs was 5.8%. The five-year median return was 3.84%.

High-yield bond strategies occupied five of the top 10 spots on the five-year CIT list, while long-duration held four spots and intermediate term, one spot. JPMAM's Corporate High-Yield Bond strategy came in first with a five-year net return of 8.89%, followed by Fidelity Institutional Asset Management's High-Yield Core Institutional, 8.25%; JPMAM's High-Yield Fund, 8.1%; PGIM Inc.'s High-Yield Fund 1, 7.96%; and JPMAM's Long-Credit Fund, 7.39%.

All data for Pensions & Investments top-performing managers report are provided from Morningstar's global separate account/ collective investment trust database. The data for the rankings on which this story is based were pulled Oct. 25.