After heady 2020, bond managers prep for shifts

Fixed-income money managers enjoyed significant gains in assets under management for the year ended Dec. 31, and while lower returns, rising interest rates and the specter of inflation loom in investors' minds thus far in 2021, managers see these primarily as concerns in the near term.

According to Pensions & Investments' latest money manager survey, U.S. institutional tax-exempt assets managed by the top 25 active domestic fixed-income managers totaled $2.93 trillion as of Dec. 31, up 8.9% from a year earlier.

Matthew Nest, Boston-based global head of active fixed income at State Street Global Advisors, said in a phone interview that fixed-income returns in 2020 were primarily the result of macroeconomic drivers.

"It's been a big environment for the macro moves in the market," Mr. Nest said. "Interest rates and curves and spreads and the dollar and all that has really dwarfed the security selection aspect in the management of portfolios."

The top 25 passive domestic fixed-income managers saw their U.S. tax-exempt institutional AUM increase even more in 2020, reporting $1.042 trillion as of Dec. 31, up 17.5% from $886.6 billion.

Domestic and global bond managers fared well in a pandemic-driven market. For the year ended Dec. 31, the Bloomberg Barclays U.S. Aggregate Bond index returned 7.5%, and the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 10.1%.

But fixed-income returns have seen a significant reversal in 2021 thus far. For the three months ended March 31, Bloomberg Barclays' U.S. and ex-U.S. indexes returned -3.4% and -5.3%, respectively.

Those returns, as well as a rapid increase in the U.S. 10-year Treasury yield to 1.61% as of May 27 from a historic low of 0.55% last August, reflect investors' concerns about inflation.

In an April 28 statement following the conclusion of its most recent two-day policy meeting, the Federal Open Market Committee said that while inflation has risen, it has largely reflected "transitory factors." Mr. Nest said that the current hike in inflation comes primarily from the kind of supply-and-demand forces that haven't been seen in the modern era.

"We are observing classic early recovery moves in markets. We've seen higher curves, tighter spreads, higher rates," Mr. Nest said."All pretty typical market behavior in this stage of the cycle. I think what's been different has been the speed of recovery and that's caught some people off guard."

As of Dec. 31, SSGA's core fixed-income assets managed for U.S. tax-exempt institutions totaled $160.3 billion, up 15.6% from a year earlier.

Matthew Toms, Atlanta-based chief investment officer of fixed income at Voya Investment Management LLC, said in a phone interview, "You've got a demand resurgence creating goods inflation that we have generally not seen in the prior 20 years. With a correlation of demand increase, you're not having just a transitory push, it's a cyclical push."

"In the prior two cycles you've never had enough of a prominence of the cyclical inflationary force to define bond yields and inflation premiums," Mr. Toms said. "The reality is that the question in the market is: Are those long-term disinflationary forces we saw in goods over the last 20 years. ... Are they over or not?"

"The concern that the market has is that the cyclical wave will marry into a global structural force that will become longer term," Mr. Toms said, "(that) structural disinflationary forces (are) at work in the world long term."

As of Dec. 31, Voya's core AUM for U.S. tax-exempt institutions was $14.3 billion, up 13.9% from a year earlier.

Rick Rieder, New York-based managing director, CIO of global fixed income and head of the global allocation team at BlackRock Inc., said in a phone interview, "I actually don't believe that inflation is going to be durably higher. It's going to be shocked higher in the next couple of months or so, but I think the Fed's largely right."

The current problem for investors, Mr. Rieder said, is that it's better to invest in cash than to take a negative return in fixed income if returns are not exceeding real-rate inflation.

"It's just not worth owning, but then we try to get yield in the places that we think will be consistent performers that generate returns," Mr. Rieder said.

Mr. Rieder said they have been finding yield in sectors like securitized assets, residential real estate, commercial real estate and collateralized loan obligations.

"We've been dabbling a bit in emerging markets to get some yield in the portfolio," said Mr. Rieder, "and frankly put more interest rate exposure outside the U.S. in places like China where rates are incredibly stable, (as well as) parts of Europe."

Overall money flows into emerging market debt securities totaled $31.2 billion in April, according to the Institute of International Finance, up from $3 billion in March, with emerging markets in Asia accounting for nearly half of the April total.

Mr. Rieder reiterated that in this environment it's important to "think globally about where to get that interest rate exposure."

BlackRock's core fixed-income AUM totaled $150.6 billion for U.S. tax-exempt institutions as of Dec. 31, up 13.4% from the prior year.

Henry Song, Columbus, Ohio-based fixed-income portfolio manager at Diamond Hill Capital Management Inc., said in a phone interview he doesn't really expect the Fed to raise rates or change its stand on inflation because it is unlikely it would have enough data to justify those moves.

Diamond Hill reported $204 million in core-fixed income for U.S. tax-exempt institutions, up 14.6% for the year ended Dec. 31.

"The market may respond differently but I don't think the Fed is going to force anything in the near term," Mr. Song said.

James DiChiaro, New York-based senior portfolio manager at Insight Investment, said in an interview it may not matter if inflation is transitory or durable.

"The market may lack the patience to see that answer to that finality," he said.

The consumer price index could be running north of 3% for the duration of the year, and the market may fear that the Fed may make a sudden reversal on its opinion about inflation, he said.

"We definitely try to keep in mind the concerns of our investors when we're investing on their behalf," Mr. DiChiaro said. "We've begun to lighten on some of our highest-quality investment-grade long-maturity bonds. Those are the bonds that we think will react most negatively to interest rates." Insight Investment ranked as the largest worldwide manager of liability-driven investment strategies, with $798.46 billion in AUM, up 18.3%.

While returns are lower in 2021, that has not necessarily harmed fixed-income net flows, managers say. SSGA's Mr. Nest, for example, said they have seen an acceleration of flows into fixed income as clients rebalance from equity portfolios that experienced spectacular returns in the past year.

Clients of other managers are also pouring money into fixed income.

Ciaran Carr, Chicago-based head of solutions strategy at Legal & General Investment Management America, said in an interview that despite the challenges of active management in the current low-return environment, pension fund clients have accelerated their derisking efforts.

Legal & General is the second-largest worldwide manager of LDI strategies, with $700 billion in AUM as of Dec. 31, up 4.5% from a year earlier according to P&I data.

Many U.S. corporate pension plans are frozen and utilize LDI strategies. Improving funding ratios mean those plans can move along further in their glidepaths. According to Mercer, the monthly estimated aggregate funding ratio of DB plans sponsored by S&P 1500 was 96% as of April 30, up from 84% just four months earlier.

"Pension plans moving assets out of return-seeking assets have been moving into more LDI fixed income," Mr. Carr said. "That shift into more fixed income has been a significant theme for our current client base, although it has been more challenging this year from a portfolio management perspective."

Managers agree one of the biggest challenges is navigating an environment that all see as unprecedented.

"We've never seen anything like this," said Sonal Desai, San Mateo, Calif.-based executive vice president and chief investment officer of Franklin Templeton's fixed-income group, in a phone interview. "Historically, it has never been the case that central bankers have poured money into a booming economy with such abandon."

"We've never seen an experiment quite this odd," she said.