High yield, credit strategies lead the way for bond funds

High-yield bond strategies led the list of top fixed-income performers for the third consecutive quarter, taking six of the top 10 spots for the year ended Sept. 30, according to Morningstar Inc.'s separate account/collective investment trust database.

As the Treasury yield curve continued to modestly flatten during the third quarter of 2018 and the Federal Open Market Committee raised the target range for the federal funds rate a quarter point to 2% to 2.25% at its September meeting, more rate-sensitive securities underperformed relative to investment-grade corporate credit and high yield, said Emory Zink, senior fund analyst, fixed-income strategies at Morningstar in Chicago.

"If a fund held an overweight to credit, depending on security selection, it was more likely to outperform. Even within credit, lower-quality tiers outperformed higher-quality tiers, as spreads continued to tighten and U.S. economic fundamentals signaled strength. And any of those intermediate bond funds that can hold a little bit of high yield, that allocation provided a boost to returns for the quarter," Ms. Zink said.

She described the U.S. economy as strong through the period ended Sept. 30, with low unemployment, inflation hovering at around 2%, and the continuing strength of the U.S. dollar, but the global geopolitical outlook remains uncertain and managers are wondering how long credit spreads can continue to tighten.

"In general, there is a sense that the U.S. economy is strong, but with rates on a path higher and myriad geopolitical headlines, many managers are bracing for volatility, wherever it may come from," Ms. Zink said.

The median return for domestic high-yield strategies in Morningstar's universe was 2.88% for the one-year period, while the median return for Morningstar's entire domestic fixed-income universe was -0.08%.

The Bloomberg Barclays U.S. Corporate High-Yield index returned 3.05% for the 12 months ended Sept. 30 and the Bloomberg Barclays U.S. Aggregate Bond index returned -1.22% for the year.

Six strategies on the one-year list and six on the five-year list for the period ended June 30 remained among the top 10 as of Sept. 30.

The Credit Opportunities – Long Only strategy from Aegon Asset Management debuted on Morningstar's one-year list in first place with a gross 9.61% return and entered the five-year list in fourth place with an 8.03% annualized gross return. All multiyear returns are annualized.

"For us, the reason why we've been successful over the last 12 months, and over five years, is our ability to source ideas across a variety of asset classes and actively move up and down the quality spectrum of securities, issuers and sectors. We have a track record of being nimble as the business and credit cycles evolve," said James Rich, Chicago-based head of U.S. restructuring and a portfolio manager responsible for credit opportunities and emerging markets strategies.

With a concentrated number of holdings in the strategy, typically between 30 and 40, portfolio managers have found opportunities in "high yield, leveraged loans, stressed and distressed debt, investment grade, emerging markets debt, structured debt and real estate," Mr. Rich said.

He also attributed some of the credit strategy's outperformance in the one- and five-year periods to Aegon's success in identifying and leading corporate balance sheet restructurings.

"Our team has significant experience leading restructurings. In terms of the last five years, there are several that we were the leader of that have done well. Even in the last one year, we've had several restructurings that contributed to our strong performance," Mr. Rich said.

DDJ strategies

DDJ Capital Management LLC's bank loan strategy was in second place for the 12 months ended Sept. 30, returning a gross 8.87%.

"In the bank loan strategy, we have identified the B/B- rating class as an inefficient area where there is tremendous additional yield for a small amount of incremental risk because the largest buyers of bank loans, (collateralized loan obligations), have restrictions against buying this rating category. This area of the market requires a strong research team to identify companies that will consistently be able to pay back their debts," said John W. Sherman, the Waltham, Mass.-based portfolio manager of DDJ's bank loan strategy, co-portfolio manager of DDJ's U.S. Opportunistic High Yield strategy, and assistant portfolio manager of DDJ's Total Return Credit strategy.

DDJ's Total Return Credit composite, which is in Morningstar's high-yield bond category, was among the top performers in both the separate account and collective investment trust universes for the period ended Sept. 30.

"In our Total Return Credit strategy, we are overweighting our highest-conviction ideas sourced from all of our credit strategies. The collection of our highest-conviction ideas has resulted in superior performance. This strategy also benefits from guidelines that allow a higher amount of less-liquid investments, which adds to the yield on the portfolio without taking additional credit risk," Mr. Sherman said.

DDJ's Total Return Credit II composite was in fourth place among separate accounts for the year, with a gross return of 7.79%, and the strategy was in second place for the five-year period with an annualized return of 8.87%. Among CITs, DDJ's Total Return Credit I composite topped the one- and five-year lists with a net return of 8.76% for the year and a net 7.29% for the five-year period ended Sept. 30.

Mr. Sherman said: "Our focus at DDJ is on individual credits, building a true bottom-up portfolio, with a simplistic focus of identifying bonds and loans where the borrowers will pay us back at maturity and there is a structural inefficiency, such as smaller size issues or lower ratings, that is causing the yield to be higher than it otherwise should be."

Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s fixed-income composite was in third place on the one-year list, with a gross return of 8.69% for the year, and the strategy topped the five-year list with a 10.01% return for the period ended Sept. 30. Herzfeld's fixed-income composite is in Morningstar's high-yield bond category.

"The main drivers in this past quarter was our allocation to CLO equity tranches. Our underlying holdings are fixed income, but the alpha driver this quarter stems from trading around the equity component," said Erik Herzfeld, president and portfolio manager.

Mr. Herzfeld said the strategy uses products traded on exchanges to maximize efficiency while remaining nimble as opportunities arise in fixed-income markets.

"We're taking advantage of a lot of behavioral aspects, which is how we were able to deliver over a 10 alpha over the past three years. We identified CLOs that we felt were underpriced, demonstrating a favorable risk/reward opportunity in the last quarter, one of the best we've seen," Mr. Herzfeld said.

This Herzfeld strategy has been on Morningstar's top 10 list for five consecutive quarters. It was known as Herzfeld's Taxable Closed-End Bond strategy before the second quarter of 2018, and led the one- and five-year rankings for the year ended June 30.

New York-based Schroder Investment Management North America Inc.'s Opportunistic Multi-Sector Securitized strategy's gross return of 8.17% put it in third place for the five years ended Sept. 30.

Rounding out the lists, a 7.43% one-year gross return and a gross annualized 7.8% for the five-year period put the Select High Yield Composite from MacKay Shields LLC, New York, in fifth place on both the one- and five-year lists.

The annualized return for the Bloomberg Barclays' U.S. Corporate High-Yield index was 5.54% for the five-year period, the median return for high-yield strategies was 5.31%, the entire Morningstar domestic fixed-income universe returned a median 2.67%, and the Bloomberg Barclays U.S. Aggregate Bond index returned an annualized 2.16% for the five years ended Sept. 30.

Commingled universe

Shenkman Capital Management Inc.'s Four Points Multi-Strategy trust was in second place for the year in the collective investment trust universe with a net return of 6.19%, following DDJ's strategy. Fidelity Institutional Asset Management's Leveraged Loan Pool was third at 4.83%, followed by American Century Investments' U.S. High Yield Corporate Bond fund with a 4.29% return and BNY Mellon Investment Management's EB DV High Yield Beta Fund was fifth on the list with a 3.85% net return for the one-year period.

PGIM had three of the top five CITs for the five years ended Sept. 30, with its U.S. Long Duration Corporate Bond fund in second place with a net return of 6.32%, followed by the firm's High Yield Fund 1, returning 6.15%, and the U.S. Long Duration High Quality Corporate Bond fund in fourth place with a 6% return for the period.

State Street Global Advisors' U.S. Long Credit Bond Index fund rounds out the list in fifth place with a net 5.86% annualized return.

The median return for fixed-income CITs in Morningstar's universe was -0.9% for the year and 2.65% for the five years ended Sept. 30.

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 Nov. 5.