Bank loans, high yield continue to lead fixed-income performance

Fixed-income securities partially recovered in the first three quarters of 2023 following a historically poor calendar year 2022, with institutional investors hopeful that the Federal Reserve has ceased its aggressive tightening campaign in a climate of gradually declining inflation.

According to data from Morningstar for the 12 months ended Sept. 30, the median return for its domestic fixed-income universe was 3.26%, while the Bloomberg U.S. Aggregate Bond index returned 0.6% and the Bloomberg U.S. Corporate index gained 3.6%. In the third quarter of 2023 alone, the median return in Morningstar's domestic fixed-income universe was -0.67%, while the Bloomberg U.S. Aggregate Bond index fell 3.23%.

According to Morningstar's separate account/collective investment trust database, the list of top-performing bond strategies for the year ended Sept. 30 was dominated by bank loans (accounting for six of the top 10), while high-yield bonds held three spots and a muni national long bonds strategy took the remaining spot.

Thomas Murphy, research analyst at Morningstar Research Services, a subsidiary of Morningstar, said that while the Fed continued to hike short-term rates throughout 2023 in an effort to tame inflation, the bulk of that tightening had already occurred in 2022.

From March 2022 to December 2022, the central bank hiked rates seven times, increasing the federal funds rate from 0.25% to 4.5% over that period. In 2023, four additional hikes brought the figure to its current level of 5.5%, where it has been since July 26.

In this environment, bonds have "found their footing," Murphy said, noting that high-yield bonds and bank loans have delivered the best performance so far in 2023.

The fixed-income market is rather bifurcated, Murphy acknowledged. Bank loans and high yield have outperformed because the economy has remained relatively healthy and these securities are less sensitive to rate hikes compared with Treasuries and investment-grade corporate bonds, he said.

Anders Persson, CIO for global fixed income at Nuveen, which has $1.1 trillion in AUM, concurred that lower-quality and shorter-duration sectors have fared well in 2023.

"With duration and growth being the two main drivers for bond markets this year, better economic growth has helped lower-quality segments to outperform — such as high-yield corporate and senior loans, which are both shorter duration and more leveraged to economic growth," Persson said. "Longer duration has sold off further this year, albeit at a much-reduced magnitude relative to last year's sell-off."

Interestingly, Morningstar's Murphy noted that these top performers — bank loans and high yield, which tend to be low quality and below investment-grade — have recently suffered large outflows from investors. "This is likely because investors are anticipating a decline in interest rates next year and they want to move to higher-quality, longer-duration vehicles," he said. "It may also reflect a fear that the economy may enter into a recession and in that event, it's better to be in safe-haven assets."

Josh Emanuel, chief investment officer at Wilshire Advisors, asserted that the fixed-income market has not fully recovered from the declines in 2022 as rates have continued to rise on better-than-expected economic growth. "While credit markets have delivered positive returns in 2023 primarily due to high absolute yields, we have yet to see these markets fully recover," he added.

Nick Losey, managing director and portfolio manager at Barrow Hanley Global Investors, said if interest rates decline dramatically from present levels, investment-grade bonds will outperform followed closely by high yield. "Our team believes rates are likely to be higher for longer and therefore think allocations to below-investment-grade credit make sense given their equity-like return profile at the expense of existing equity allocations," he said.

The top domestic fixed-income performer for the year ended Sept. 30 was New York-based 16th Amendment Advisors' Vicksburg strategy, which posted a gross return of 74.94%. The strategy also ranked first on the five-year list, returning a gross annualized 47.6%.

John J. Lee, a co-founder and managing member of the firm, told Pensions & Investments in a previous interview that Vicksburg is a total return, institutional fixed-income strategy and that it holds investment-grade municipal bonds, corporate bonds and their hedges in a strategy that is targeted to investors looking for non-correlated, high-grade fixed-income exposure.

The second-best performer on the one-year list was Oaktree Capital Management's European high-yield bonds strategy, which returned a gross 15.29%. According to Oaktree's website, this vehicle invests primarily in high-yield bonds issued by European issuers and on an ancillary basis in high-yield bonds denominated in European currencies issued by North American issuers. Oaktree officials declined to comment.

Morgan Stanely Senior Loan Plus (formerly Eaton Vance Senior Loan Plus) and Calvert Floating-Rate Advantage, both bank loan strategies, came in third and 10th place, respectively, delivering one-year gross returns of 14.98% and 14.18%.

Christopher Remington, managing director and institutional portfolio manager for Morgan Stanley Investment Management (which owns both Eaton Vance and Calvert), said no one should be surprised by the strong performance of senior loans. "Rising rates impair fixed-rate returns, while these same conditions are a tailwind for floating-rate assets," he said. "Loans are essentially 'inside-out bonds' and this characteristic has made them an ultra-diversifier for pension plans."

Ranked fifth was Invesco's European bank loans composite strategy, returning a gross 14.91%.

“European loans have demonstrated consistent performance, offering a stark contrast to other risk assets,” said Michael Craig, head of European senior loans at Invesco.

He further noted: "European loan coupons are at an all-time high, offering investors an opportunity to earn substantial returns. The floating-rate feature is a positive in a rising interest rate environment, making them a suitable investment choice in such scenarios."

"European loans offer one of the highest yields in fixed income with no duration risk, making them a compelling investment option," Craig added.

Behind Invesco in sixth place was Franklin Templeton's global high-yield strategy with a gross return of 14.57%.

Glenn Voyles and Tricia O'Connor, portfolio managers at Franklin Templeton, attributed this strong performance primarily to security selection over the past year. "We have a large and experienced team of 33 global credit research analysts and expect their highest conviction research ideas to drive alpha in the portfolio," they said in a joint email response. "The High Yield team takes a longer-term investment horizon — three to five years — which allows the team to be contrarian during bouts of volatility."

Artisan Partners' Floating Rate Composite strategy returned a gross 14.36%, making it the seventh-best one-year performer. Another one of the firm's strategies, Artisan High Income, ranked ninth on the five-year list, with a 5.22% annualized gross return.

Bryan Krug, founding portfolio manager of Artisan Partners' credit team, said both strategies focus on "high-conviction investing with an emphasis on business quality," adding that "security selection has been the primary driver of excess returns."

Krug noted the strategies have taken advantage of the "less-efficient, lower-quality part of the credit market – Bs and CCCs – adding value by identifying mis-rated credits that are fundamentally sound, as we have since the inception of both strategies."

Barrow Hanley's bank loan strategy showed up in the top 10 for both the one-year and five-year periods – racking up a one-year gross return of 14.29% and five-year annualized gross return of 5.16%. "(Our) teams process and analyze all available information to make sure that we invest in attractive positions at an appropriate time to own that security," Losey said. "We are constantly surveying the market as to relative value amongst names, industries, ratings, and single name swap opportunities. We historically have been able to nimbly maneuver the portfolio on the margin towards safety or take advantage of convex opportunities that the market presents, fighting for incremental performance or risk reduction as necessary."

The top 10 list for the five-year period ended Sept. 30 was slightly more diversified, comprising four high-yield strategies, three multisector strategies, one muni national long bond strategy, one corporate bond strategy and one bank loan strategy.

For the five-year period, the median return was 1.53%

In second place after 16th Amendment's Vicksburg strategy was Newport Investment Advisors' investment flexible bond strategy, returning a gross annualized 8.22%.

Kenneth Holeski, president, founder, and co-CIO, and Justin Holeski, senior vice president and co-CIO, at Newport Investment Advisors, said in a joint email statement that 2022 "represented one of the worst bond markets in 30 years. Once again, tactical and reactive allocation had us predominately invested in cash and equivalents with a very short strategic trade made in midyear to high-yield municipal bonds."

They added that in 2023 they included the largest number of categories and holdings in company history.

"Early in the year, we exited large positions in high-yield municipals and floating-rate securities. Since then, positions have evolved into mortgage-backed securities, investment-grade corporates, short-term investment grade and high-yield municipals once again."

They added: "Obviously, we are sector-indifferent, with an emphasis on capital preservation."

The third-best five-year performer was the Herzfeld Fixed Income Composite, which returned an annualized gross 7.36%.

"We have been bearish (on) duration since January of 2022 and recently turned bullish," said Ryan Paylor, portfolio manager at Thomas J. Herzfeld Advisors.

"Holdings in floating rate, private credit, and fixed income (closed-end funds) undergoing activism were performance-drivers over the last year. We have trimmed floating rate and private credit holdings while adding term preferred shares and higher credit quality bonds."

The Milwaukee Institutional Asset Management focused fixed-income value strategy ranked fourth over the five-year period with an annualized gross return of 6.47%.

This strategy holds a concentrated portfolio of 10-12 positions and uses a bottom-up fundamental investment approach to identify improving credit situations, said J.P. Geygan, chief operating officer and senior vice president at Global Value Investment Corp., the parent company of MIAM.

"We are long-term value investors and expect price appreciation of our investments as underlying business fundamentals improve and as the notes near maturity," Geygan said.

The strategy has the flexibility to invest in securities with varying duration and credit quality, he said. As such, the strategy may invest in securities that are overlooked or undervalued by the market typically for temporary or unsupported reasons. Consequently, Geygan noted the portfolio can own both investment-grade securities as well as non-investment-grade securities that are expected to eventually move up to investment-grade status. MIAM's focus on unrecognized quality has allowed the portfolio to maintain very low turnover as a result of infrequent trading, he said.

In fifth place behind MIAM was Brandywine's global high-yield strategy, returning a gross annualized 6.25%.

"As a full-cycle manager, we want to outperform the most in down markets and then, if we capture our fair share of the strongest markets, we believe we will rise to the top over a complete market cycle," said John McClain, portfolio manager. "That is what happened in the five years through September 2023, with down markets in the fourth quarter of 2018, the first part of 2020, and the first half of 2022."

Mesirow's high-yield strategy delivered a 5.49% annualized gross return over the past five years, making it the seventh-best performer on the five-year list.

Robert Sydow, chief investment officer and portfolio manager, said the high-yield team looks for companies that appear risky to other investors — and therefore yield significantly more than the index — for reasons that are not really fundamental to their businesses.

"We often discover such opportunities with small to midsize companies, in small industries which are relatively unfollowed and unknown, and with first time issuers, complex companies, entrepreneur-owned companies, and lower-rated securities," he added. "These are where we find overcompensated credit risks. If we can find about 100 of these companies and know them exceptionally well, we believe we can capture the excess coupon income and still sustain much lower-than-average defaults."

Within Morningstar's collective investment trust universe, the most heavily represented category was once again high-yield bonds, which accounted for six of the top 10 spots for the year ended Sept. 30. The other four were bank loans.

For the year ended Sept. 30, the median return for domestic fixed-income CITs in Morningstar's database was 2.01%.

Mesirow's high-yield CIT, T. Rowe Price's floating rate CIT, and Prudential's bank loan CIT ranked first, second and third, respectively, with net returns of 13.27%, 13.03% and 12.51% for the year ended Sept. 30.

They were followed by Fidelity's floating rate high income CIT and T. Rowe Price's high-yield CIT, which returned a net 12.46% and 11.71%, respectively.

For the five years ended Sept. 30, T. Rowe Price' floating rate CIT was the top performer with an annualized net return of 4.78%.

Over the five-year period, the median annualized return for domestic fixed-income CITs in Morningstar's database was 0.95%.

All data for Pensions & Investments' top-performing managers report is provided from Morningstar's global separate account/collective investment trust database. Data for the separate account and CIT rankings on which this story is based was pulled on Nov. 14.