High yield continues to produce highest returns

High yield continued to dominate the list of top-performing fixed-income strategies for a second consecutive quarter, according to Morningstar Inc.'s separate account/collective investment trust database. Nine of the top 10 fixed-income strategies in the separate account universe were in Morningstar's high-yield bond category for the year ended June 30, up from seven for the one-year period ended March 31.

Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago, said both high-yield and investment-grade corporate bonds have had better returns so far in 2021 than last year, with fixed-income assets performing well in the second quarter, overall.

"We've seen both investment-grade and high-yield spreads tighten to almost all-time — if not all-time — lows with this understanding that as the economy reopens and as COVID 'comes to an end,' companies, generally, are going to be having much stronger performance," Mr. Denis said.

He said the first quarter of 2021 saw investors moving out of U.S. Treasuries, especially at the longer end of the curve, driven by general concerns about higher-than-expected inflation as the vaccine rollout proceeded and the economy reopened. Since August 2020, the Federal Open Market Committee has maintained a policy that targets an average, over time, of 2% inflation before moving to raise rates. However, economic projections of Federal Reserve board members and Federal Reserve bank presidents, announced in June 2021, signaled a more hawkish stance on monetary policy, giving markets an indication that the Fed could move to raise rates earlier than expected.

"If the first quarter was 'inflation!' with an exclamation mark, the second quarter was 'inflation?' with a question mark. There was a lot more uncertainty in terms of how investors digest the planned, big spending changes by the Biden administration, how the markets are understanding what inflation would look like, especially for U.S. investors, and how the U.S. Federal Reserve is going to react to all that," Mr. Denis said.

Investment-grade corporate bonds are more closely correlated with Treasuries, he said, in the sense that they tend to have longer durations and tend to move in sync when Treasury yields rise or fall.

"Investment-grade corporates took a little bit of a beating the first quarter and those yields rallied a bit (in the second quarter) as the longer-dated Treasuries and the Treasury index, as a whole, had a stronger return. Investment-grade corporates moved right alongside that," Mr. Denis said.

"We're still kind of waiting and seeing what exactly happens with the various COVID variants, with this infrastructure bill, but the kind of broad consensus, generally over the second quarter, was that we were probably heading into a much stronger economic environment," he said.

For the year ended June 30, the median one-year return for domestic high-yield strategies in Morningstar's universe was 14.52%, and the median return for Morningstar's entire domestic fixed-income universe was 3.1%.

The Bloomberg Barclays U.S. Corporate High-Yield index returned 15.4% for the one-year period ended June 30. By comparison, the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 4.6%, and the Bloomberg Barclays U.S. Aggregate Bond index had a one-year return of -0.3%.

Los Angeles-based L&S Advisors Inc.'s Short-Duration High-Yield strategy topped Morningstar's list with a gross 34.29% return for the year ended June 30. The strategy was in second place for the year ended March 31.

L&S takes a balance sheet-driven approach to managing the portfolio, speaking with the companies' management teams and selecting attractively priced high-yield issues from companies that show the potential for balance sheet improvement, said Matthew Nussbaum, a portfolio manager and senior analyst.

As an example of the firm's approach, Mr. Nussbaum said the portfolio held Antero Resources Corp., an oil and natural gas company, with high conviction after speaking with management and seeing the company's potential to execute a strategy that would provide free cash flow going forward and balance sheet improvement.

"We're not looking for troubled companies, to see that the bond is trading above recovery value and liquidation value. We're looking for consistently improving cash-flow ability, for the ability to cover interest. That gives us the comfort to say we're going to get paid on our investment and our clients are going to benefit from it," said Bennett Gross, president of L&S Advisors.

The concentrated portfolio holds 35-40 companies, with no single issue occupying more than 4% of the portfolio.

For the year ended June 30, Kenneth Malamed, a senior managing director at L&S, said "We were buying good companies with long histories that were trading at stress levels, which is what allowed us to produce a 30-plus percent rate of return in a bond portfolio, something that doesn't happen very often."

Mr. Malamed said the portfolio managers found companies with the potential for improvement across multiple sectors, from Antero in energy, to names in retail and the industrial sector. He said the common themes the portfolio managers look for are management's willingness to speak candidly and manage through disruptions.

"So far in 2021, we're having a very good year, well above the benchmarks. We expect the year will continue that way because these opportunities continue to exist and companies are finding opportunities to improve their balance sheets with the tremendous amount of liquidity available in the economy. Is it a straight line? Absolutely not. But we are confident in what we own," Mr. Malamed said.

Looking forward, he said the portfolio's managers expect to find continued opportunities in the short-duration high-yield market, which provides higher-than-average rates of return with less-than-average risk.

The short-duration portfolio is limited to a maximum five-year maturity, on a rolling basis.

L&S Advisors' High-Yield strategy, which is managed by the same team, was in fifth place on Morningstar's list with a gross 24.35% return for the year. The High-Yield strategy has a maximum maturity of 10 years, on a rolling basis.

Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s Fixed-Income composite was in second place on the one-year list, with a gross 31.27% return and topped the five-year list with a gross annualized 11.28% return for the period ended June 30. The strategy, which is in Morningstar's multisector bond category, was in fourth place on both the one- and five-year lists for the period ended March 31.

Erik Herzfeld, president and portfolio manager, said the portfolio has remained nimble, maintaining its high-yield stance during the quarter ended June 30, while benefiting from short Treasury positions, such as trading 10-year Treasuries in the 120- to 125-basis-point range.

"Whenever we get a bond rally, we take some profit. And when there's a sell-off, we add exposure. So, lots of trading opportunities. I think that's helped our performance," he said.

The portfolio's view is not typically driven by macroeconomic indicators, Mr. Herzfeld said, but with recent reports showing market liquidity at its lowest point since March 2020 and August 2021's upcoming Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City, Mo., Mr. Herzfeld sees the possibility of rate changes that could bring a different set of opportunities later in the year.

"I just think that the market has gotten complacent. You can't run a -3.5% real rate forever, so I think that at some point you're going to have to see some yield. We're keeping our duration quite limited, quite short," he said.

Managers are also keeping the portfolio liquid, "the highest it's been for about three or four years," to remain flexible for upcoming opportunities and potential rate changes, Mr. Herzfeld said.

Flexibility over the long term is important to the portfolio's managers as well. In looking at the portfolio's five-year performance, Mr. Herzfeld said, "We spend a lot of time looking in places that others don't. We try to be nimble. We try to keep our book flexible. If we change our mind on something, we try to reflect it. We don't get married to a particular view."

Third on the one-year list was First Trust Portfolios LP's Taxable Closed-End fund, with a gross 29.5% return for the year. A 27.17% gross return for fourth-place ranked Mesirow Financial's High-Yield strategy rounded out the top-5 list for the one-year period.

Diamond Hill Capital Management's High-Yield strategy was in second place on Morningstar's five-year list, with a gross annualized 11.03% return for the period ended June 30.

"The best way to put it is we take a commonsense approach to the high-yield market, which is surprisingly uncommon," said Bill Zox, the strategy's co-portfolio manager.

The selection process puts more of an emphasis on the quality of management, management's ability to allocate capital, their ability to operate the business and "intangible" assets that might be undervalued by fixed-income investors, he said.

Mr. Zox said technology businesses are a good example of the type of intangible assets the strategy's portfolio managers consider.

"Technology businesses are very highly valued in the equity markets, but bond investors are not as comfortable with them because the assets are intangible. They're not hard assets that you can sell off in a liquidation. That's sort of a relic of the past, in the way credit investors look at things, the way ratings agencies look at things. They place too much emphasis, in our view, on the liquidation value of hard assets, rather than the quality of the business," Mr. Zox said.

Insurance brokers are another good example, he said. Client relationships are "very sticky and very valuable" for insurance brokers, which equity investors tend to recognize, but bond rating agencies and high-yield investors don't tend to look as favorably on insurance brokers because those intangibles don't have a liquidation value, he said.

For the five-year period ended June 30, Mr. Zox said the strategy held up well during difficult markets, such as the last quarter of 2018 and the first quarter of 2020, but it is not always a defensive strategy.

"What you find is, most investors that hold up well during down markets are always on defense, and they don't capture their fair share of up markets. So, it looks great on March 23, 2020. But as the market turns, their performance falls farther and farther toward the bottom. To always be defensive in the high-yield markets does not make sense to us. It's kind of like picking up nickels in front of a steamroller. You have to make money in high yield when it's time to make money because you're bearing significant risk," Mr. Zox said.

In describing the overall composition, Mr. Zox said the portfolio has greater exposure to small- and midsized issuers, rather than the largest issuers in the high-yield space.

"That's the important difference from an equity index, where the largest weights in the equity index are the largest because they created the most value. In the high-yield index, they're the largest because they borrowed the most money. So it really doesn't make sense to own something just because it's a large weight in the benchmark," he said.

Diamond Hill's High-Yield strategy was acquired by Philadelphia-based Brandywine Global Investment Management LLC, effective July 30. The strategy's co-portfolio managers, Mr. Zox and John McClain, along with fixed-income senior associate Jack Parker, joined Brandywine's global fixed-income team and continue to manage the portfolio, which was reorganized as the BrandywineGLOBAL High-Yield fund.

MacKay Shields LLC's Select Credit Opportunities composite was in third place for the five-year period, with a gross annualized 10.45% return, followed by an annualized 9.53% return for Artisan Partners Asset Managment Inc.'s High-Income strategy. Shenkman Capital Management Inc.'s Multi-Strategy composite rounded out the top five for the five-years ended June 30 with a gross annualized 9.39% return.

The median five-year return was an annualized 7.17% for Morningstar's domestic high-yield universe and an annualized 3.64% for Morningstar's entire domestic fixed-income universe.

The Bloomberg Barclays U.S. Corporate High-Yield index returned an annualized 7.5% for the five years ended June 30, the Bloomberg Barclays U.S. Aggregate Bond index had an annualized 3% return and the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned an annualized 1.6% for the five-year period.

High yield leads CITS High-yield fixed-income strategies also came out on top in Morningstar's domestic collective investment trust universe for the one- and five-year periods ended June 30. High yield once again held all of the top 10 spots for the year and held eight of the 10 spots on the five-year list, down from nine spots at the end of the previous quarter.

Mesirow Financial's High-Yield CIT moved into first place on the one-year list with a net return of 28.45%, up from second place for the year ended March 31.

A net 23.39% return for DDJ Capital Management LLC's Total Return Credit I composite lifted the strategy into second place from fifth on the one-year list. A net annualized 7.83% return put the strategy in third place for the five-year period.

After leading the list for the year ended March 31, Mellon Investment Management's DB NSL Efficient Beta Fallen Angels fund came in third with a net 19.54% return for the year ended June 30.

Barings LLC's U.S. High Yield CIF A was in fourth place with a net 18.91% return for the year.

Northern Trust Asset Management's High-Yield Fixed-Income fund was in fifth place on both the one- and five-year lists with a net 17.94% return for the one-year period and a net annualized 7.67% return for the five years ended June 30.

Shenkman Capital's Four Points Multi-Strategy fund led the five-year period among CITs with a net annualized 8.47%.

Prudential Financial Inc. rounded out the top five with two strategies on the five-year list. Prudential's High-Yield Fund 1 was in second place with a net annualized 8.16% return, and the firm's U.S. Long Duration Corporate Bond Fund 1 was in fourth place with an annualized 7.75% for the five years ended June 30.

All data for Pensions & Investments' top-performing managers report are provided from Morningstar's global separate account/collective investment trust database. Data for the rankings on which this story is based were pulled Aug. 5.