Long-duration strategies take bonds mantle from high yield

Long-duration strategies were the top performers in fixed income for the year ended Dec. 31, according to Morningstar Inc.'s separate account/collective investment trust database.

Seven of the top 10 fixed-income strategies in the separate account universe were in Morningstar's long-duration bond categories, an abrupt change from the first three quarters of 2017 in which high-yield bonds dominated the one-year top 10 lists.

Emory Zink, fund analyst, fixed-income strategies at Morningstar in Chicago, said the long-duration end of the fixed-income yield curve remained relatively steady during the quarter ended Dec. 31 due to a variety of factors, including consistent demand for long-term bonds, pre-emptively priced-in rate hikes and persistently low inflation expectations.

Because good sector calls were key to outperformance, Ms. Zink said long-duration strategies that were overweight investment-grade corporate credit performed well for the year ended Dec. 31.

"There was enthusiasm in the markets and when tax reform passed, that emboldened the markets further. An investment-grade credit position did very well," she said.

Ms. Zink said high-yield corporate credit posted a positive return for the fourth quarter but the sector saw outflows compared to investment-grade during the fourth quarter as some investors questioned the future of higher-risk assets.

"Investors are asking how long this risk-on environment can continue. They're pulling back a little bit and you can see that in the difference between high yield and investment-grade credit," Ms. Zink said.

The median return for long-duration strategies in Morningstar's universe was 10.92% for the one-year period, while high yield returned a median 7.45% and the median return for Morningstar's entire domestic fixed-income universe was 3.93% for the year.

The Bloomberg Barclays U.S. Long-Duration Corporate Bond index returned 12.09% for the year ended Dec. 31, Barclays' U.S. Corporate High-Yield index returned 7.5% and the Bloomberg Barclays Aggregate Bond index returned 3.54% for the period.

Although the Federal Reserve has new leadership, with Jerome H. Powell succeeding Janet Yellen as chairman, Ms. Zink said fixed-income investors don't expect to see dramatic policy changes at the Fed. The process of balance-sheet normalization is expected to continue and investors still anticipate multiple interest-rate increases during 2018, she said.

TCW Group Inc.'s AlphaTrak strategy led the domestic fixed-income list with a gross return of 21.92% for the one-year period ended Dec. 31 and topped the five-year list with an annualized gross return of 18.01%.

AlphaTrak topped the list of one-year gross returns each quarter of 2017 and has led the five-year list since the third quarter of 2016.

Morningstar classifies AlphaTrak as ultrashort fixed income but TCW considers it an enhanced equity indexing strategy that uses S&P 500 futures to get equity index exposure while short-term fixed-income securities are actively managed to enhance returns above the index.

AlphaTrak's fixed-income component is diversified across bond issues including Treasuries, short-term corporate bonds, asset-backed securities, and agency and non-agency commercial and residential mortgage-backed securities.

"A majority of the absolute return came from the equity market but incremental benefits came from spread tightening across various sectors of the fixed-income market, including sectors like CMBS, non-agency RMBS and investment-grade corporate bonds," said Bryan Whalen, fixed-income portfolio manager at TCW in Los Angeles.

The S&P 500 returned 21.83% for the year ended Dec. 31 and an annualized 15.79% for the five-year period. The Bloomberg Barclays U.S. Mortgage-Backed Securities index returned 2.47% for the year and an annualized 2.04% for five years.

Two strategies from Pacific Investment Management Co. LLC, Newport Beach, Calif., were among the top 10 on the one-year list. PIMCO's Long-Term Credit strategy was in second place with a one-year gross return of 14.44% and the Long Term Bond Full Authority strategy was in seventh place with 12.91% for the year.

Logan Circle Partners LP's Long Credit corporate bond strategy ranked third with a 13.59% gross return for the year. It was followed by Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s Taxable Closed-End Bond strategy in fourth place with a gross one-year return of 13.53%.

Herzfeld Advisors' strategy was in fifth place on the list for the year ended Sept. 30.

The strategy buys shares of closed-end funds and builds a portfolio composed of 25 to 30 fixed-income funds that have advantageous price dislocations, said Erik Herzfeld, president and portfolio manager.

"With closed-end funds, there's the net asset value but there's also the execution price, which tends to move around more than net asset value," he said. "Seventy percent of closed-end fund buyers are retail in nature and retail buyers are emotional beings and they tend to affect prices more. We've been focusing on this phenomenon for more than 30 years."

Portfolio managers choose fixed-income funds that are "trading at a discount, from premier investment managers such as PIMCO, BlackRock, Nuveen and DoubleLine Capital," said Herzfeld portfolio manager Ryan Paylor.

"The first step is the manager doing well. We're using our technical prowess to build a portfolio on our understanding of how these investment companies work," he said.

When the price of an underlying fund returns to the mean, the strategy can maintain its conviction relative to duration and sector exposure through correlation trades for funds that are in the same space but are trading at a lower cost, Mr. Paylor said.

"We're not necessarily making a big call on credit or a big call on duration. We're letting the best-of-breed managers do that. What we do is buy at prices lower than net asset value and sell them when we feel they are no longer attractive, taking advantage of that price dislocation. As a result, we can add incremental alpha. We have a chance to profit from more than just net asset value appreciation," Mr. Herzfeld said.

Completing the top five for one-year returns was the Dodge & Cox Long Duration Credit strategy, which returned a gross 13.07%. San Francisco-based Dodge & Cox's Long Duration FI Composite was also in the top 10, finishing the year in eighth with a 12.77% gross return.

High-yield strategies continued to dominate the list of top performers for the five-year period ended Dec. 31. Seven of the strategies on the list were in Morningstar's high-yield bond category and all seven were also among the top 10 for the five years ended Sept. 30.

The annualized return for Bloomberg Barclays' U.S. Corporate High-Yield index was 5.78% for the five-year period, the median domestic high-yield bond return was 5.71% and the entire Morningstar domestic fixed-income universe returned an 2.52% for the five years ended Dec. 31. All multiyear returns are annualized.

New York-based Schroder Investment Management North America's Opportunistic Multi-Sector Securitized strategy's gross return of 8.46% put it in second place behind TCW's AlphaTrak for the five years ended Dec. 31.

The Select High Yield Composite from MacKay Shields LLC, New York, was in third place for the third consecutive quarter with a 8.31% return.

Jersey City, N.J.-based Lord, Abbett & Co. LLC's High Yield Opportunistic strategy came in fourth with a gross return of 7.87%. The strategy was in sixth place for the five years ended Sept. 30.

An intermediate-term bond strategy from Flaherty & Crumrine Inc., Pasadena, Calif., rounded out the top five on the five-year list with an 7.87% return for the period.

In the collective investment trust universe, two strategies from Fidelity Institutional Asset Management topped the one-year list. FIAM's Long U.S. Treasury STRIPS Pool led all domestic fixed-income managers for the year ended Dec. 31 with a net return of 13.75% and FIAM's Long Corporate Pool was in second place with a net 12.34%.

Blackrock Inc.'s Long Corporate Bond Index strategy was in third place at 12.33%, State Street Global Advisors' U.S. Long Credit Bond Index was fourth at 12.31% and BNY Mellon Investment Management's EB LT Credit Bond Index rounded out the top five with a 12.26% net return for the year.

DDJ Capital Management LLC's Total Return Credit I Composite led the CIT list for the five years ended Dec. 31 with a net return of 7.94%. DDJ has held the top spot for three consecutive quarters.

Prudential Financial Inc.'s High-Yield Fund 1 was in second place with a net 6.15% return, followed by Eaton Vance Corp.'s EB High Yield I at 5.97%, BNY Mellon's EB DV High Yield Beta Fund at 5.74% and Wellington Management Co. LLP's CIF II High Yield Bond completed the top five with a net 5.4% return for the five-year period.

The median return for fixed-income CITs in Morningstar's universe was 4.2% for the year and 2.51% for the five years ended Dec. 31.

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 Feb. 1.