Bond strategies rebound in Q1 after difficult 2022

While bonds rallied in the first quarter of 2023 amid falling yields and hopes that the Federal Reserve's tightening cycle was nearing an end, a difficult 2022 set most domestic fixed-income strategies back and resulted in muted returns for the 12-month period ended March 31.

According to Morningstar Inc.'s separate account/collective investment trust database, the top 10 performing managers for the year ended March 31 represented a variety of strategies. Two strategies each fell under the following categories: muni national long bonds, ultrashort bonds, multisector bonds and bank loans. For the remaining strategies, one fell under non-traditional bonds and the other under muni national intermediate bonds.

For the year ended March 31, the median return in Morningstar's domestic fixed-income universe was -1.22%; while the Bloomberg U.S. Aggregate Bond index returned -4.78% for the period.

However, in the first quarter of 2023, the median return in Morningstar's domestic fixed-income universe was 2.4%, while the Bloomberg U.S. Aggregate Bond index rose 2.96%.

Thomas Murphy, Chicago-based manager research analyst at Morningstar Research Services LLC, a subsidiary of Morningstar Inc., said in an interview that 2022 was a "historically bad" year for fixed income as bond prices across most sectors were crushed and "nothing seemed to work no matter where you looked."

Indeed, the Bloomberg U.S. Aggregate Bond index plunged 13.01% in 2022.

However, in the first quarter of 2023, bonds rebounded as yields fell and investors dipped back into fixed-income strategies despite continued uncertainty around high inflation, he added.

"The Fed hiked rates by an unprecedented 475 basis points over the last year to combat inflation," he said. "But in the new year we appear to have some optimism as bonds are offering income levels investors have not enjoyed in years."

While bonds delivered generally good returns in the first quarter, Mr. Murphy cautioned that volatility remained in force, exacerbated by turmoil in the regional banking industry. "It's been an up-and-down year so far in 2023," he observed.

Generally, fixed-income securities with longer duration and lower credit quality fared the best so far this year, he noted.

The top domestic fixed-income performer for the year ended March 31 was New York-based 16th Amendment Advisors LLC's Vicksburg strategy, which posted a gross return of 64.44%. The strategy also ranked first on the five-year list, returning a gross annualized 40.84%.

John J. Lee, a co-founder and managing member of the firm, told Pensions & Investments in November 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.

Behind 16th Amendment on the one-year list was Federated Hermes Inc.'s trade finance strategy, which returned a gross 7.24%. Christopher McGinley, Pittsburgh-based vice president, senior portfolio manager and head of the trade finance team at Federated Hermes, said in an interview that "trade finance" can be considered a subset of the loan market and essentially provides short-term floating rate loans that enables the flow of goods across borders.

"The overall investment philosophy of Federated Hermes places a premium on diversification and the trade finance strategy reflects that since it works as a diversified source of alpha," he said.

Mr. McGinley partly attributed the strategy's recent outperformance to the fact that it is a floating-rate product amid an environment of rapidly rising interest rates. "As a result, it has negligible interest rate risk," he added.

Miami-based Potomac Fund Management Co.'s income plus strategy ranked third, racking up a 7.21% return.

Dan Russo, a Manhasset, N.Y.-based portfolio manager at Potomac, said by email that his firm's investment philosophy is to "win by losing less."

"We believe that risk can be contained, even conquered, through the thoughtful use of objective and well-tested market indicators," he said. "These indicators are used to identify times when probabilities favor having 'risk on' and times when the risk is not worth the reward."

The income plus strategy fits this philosophy, he explained, by "using a tested set of market indicators to identify times of opportunity in the riskier parts of the fixed-income market and times when risk should be avoided and/or mitigated."

Income plus is a tactical total return strategy with the goal of providing stable and absolute returns under all market conditions, he noted. "The core position in the strategy focuses on absolute return and low daily volatility," he added. "When our indicators identify a risk-on environment, the core position seeks exposure to the high-yield bond market, the high-yield municipal market and emerging market bonds." But when the environment calls for a risk-off stance, he indicated, the core position uses "trend and momentum analysis to identify assets that may outperform in such an environment. This includes the use of cash."

The specific drivers of outperformance by the income plus strategy were derived from the fact that the firm's indicators recognized that the environment had become more risk-off, Mr. Russo added.

"This kept the main holding in the strategy from having outsized exposure to riskier pockets of the fixed-income market," he said. "At the same time, our trend and momentum analysis guided us toward exposures that benefited from higher interest and a stronger U.S. dollar. Importantly, we do not simply defer to Treasuries in a risk-off regime."

Ranked fourth on the list was Eaton Vance Management's global macro absolute return strategy, posting a 6.01% gross return.

The global macro strategy is a long/short absolute return strategy focused on sovereign or sovereign-related assets like foreign exchange, sovereign hard currency credit and local interest rates, said Kyle Lee, Boston-based portfolio manager for the strategy, in an email.

Mr. Lee said the emerging markets team's investment philosophy is that "fluctuation in sovereign risk premium is the primary driver of capital market returns over the medium to long term." Therefore, he explained, his team focuses on "deep research into individual countries' economic policies, which are the drivers of sovereign risk premium." "We look across the entire spectrum of investible countries — today approximately 130 of them — to find these opportunities, often in less efficient markets with especially high potential returns," he said.

During the one-year period ended March 31, while global capital markets were "certainly challenged," Mr. Lee said, long positions in local markets in Ukraine, Dominican Republic, and Uzbekistan were "notable drivers of performance," while short positions in the Chinese yuan and South African rand, among others, were "all key contributors to returns."

Ukrainian local assets, he added, rebounded off of their lows following Russia's invasion, while the Dominican Republic and Uzbekistani markets "both benefited from sound monetary policy and its impact on inflation."

BNP Paribas Asset Management's mortgage alpha strategy posted the fifth-best performance among domestic-fixed income vehicles for the year ended March 31, delivering a gross return of 5.41%.

Matt Slootsky, New York-based portfolio manager at BNP Paribas, said in an interview that the strategy focuses on agency mortgage-backed securities and that the team seeks "to generate excess returns by capitalizing upon inefficiencies in the MBS market, leveraging our views on prepayments, volatility and risk."

Thomas J. Herzfeld Advisors' tax-exempt composite strategy was in sixth place with a 4.48% gross return. This strategy also showed up as the fifth-best performer for the five-year period ended March 31, delivering an annualized gross return of 6.66%.

Another Herzfeld strategy, the Herzfeld fixed-income composite, occupied the third spot on the five-year list, returning a gross annualized 6.81%.

Erik Herzfeld, Miami Beach, Fla.-based president and portfolio manager, said his firm takes a contrarian investment approach, seeking out "undiscovered value" assets that are not properly valued based on their true fundamentals.

With respect to the Herzfeld tax-exempt composite strategy, which invests in municipal bonds, Mr. Herzfeld said the team was overweight in floating-rate bonds for most of 2022, and then rotated back into fixed-rate exposure earlier this year "as yields became the most attractive in years."

The Herzfeld fixed-income composite was a similar story — the theme was focusing on locking in high rates.

"Floating-rate credit exposure, such as the lower tranches of (collateralized loan obligations), served us well in 2022 but we were looking to lock in high rates as the Fed approached the end of its tightening cycle," Mr. Herzfeld said.

For the five years ended March 31, four of the top 10 strategies fell within Morningstar's high-yield bond category.

Rounding out the five-year list, behind 16th Amendment's 40.84% gross annualized return for its Vicksburg strategy, was Hi-Line Capital Management's income advantaged strategy, returning a gross annualized 8.52%. In fourth place was Wellington Management Co.'s credit total return strategy, returning 6.75%.

For the five years ended March 31, the median annualized return in Morningstar's domestic fixed-income universe was 1.91%, while the Bloomberg U.S. Aggregate Bond index returned an annualized 0.9% for the period.

Within Morningstar's collective investment trust universe, the most heavily represented categories were short-term bonds and bank loans, occupying five and four of the top 10 spots for the year ended March 31, respectively. The other top performer was a short-term government strategy.

For the year ended March 31, the median return for domestic fixed-income CITs in Morningstar's database was -4.76%.

State Street Global Advisors' Cash Series Short-Term Investment Non-Lending Index C and Northern Trust Asset Management's Short-Term Investment Fund CIT ranked first and second, respectively, returning a net 2.98% and 2.95% for the year ended March 31.

They were followed by T. Rowe Price Group's Floating Rate Trust Z, 2.94%; Fidelity Institutional Asset Management's Floating Rate High Income Pool, 2.72%; and PGIM's Bank Loan Fund 1, 0.64%.

For the five years ended March 31, MacKay Shields LLC's High Yield Bond CIT Class 1 was the top performer with an annualized net return of 4.1%.

Over the five-year period, the median annualized return for domestic fixed-income CITs in Morningstar's database was 1.41%.

All data for Pensions & Investments' top-performing managers report are 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 were pulled May 5.