High yield, inflation drive bond strategies

High yield once again held the most spots among the 10 top-performing fixed-income strategies for the year ended Dec. 31, according to Morningstar Inc.'s separate account/collective investment trust database, as inflation rose but the corporate default rate remained relatively low.

"Even though we're already into February, a lot of the things that we're concerned about now are things that started last quarter," said Gabriel Denis, a senior manager research analyst at Morningstar in Chicago.

In the fourth quarter of 2021, Federal Reserve officials signaled the potential for aggressive rate hikes in 2022 and began tapering the Fed's bond-buying program. The Treasury yield curve flattened slightly during the quarter, as rising inflation and the potential for rate hikes put upward pressure on the short end and fears around the omicron variant of the coronavirus pushed yields on the long end lower. Investment-grade and high-yield corporate credit had positive returns for the quarter, and the default rate remained low as companies were able to meet their debt obligations, although credit spreads remained tight, Mr. Denis said.

"Essentially, the idea that corporate markets were very strong stemmed partially from the pace of economic recovery being on track. Even with omicron worries, corporate defaults were incredibly low compared to what was originally projected when COVID first broke out in 2020," he said.

Mr. Denis said in addition to risk assets like corporate debt showing a positive return in the fourth quarter, Treasury inflation-protected securities and U.S. leveraged loans also performed well because they have structural qualities that responded well to the environment.

"With TIPS, their principal adjusts depending on inflation, so they had a very strong year as inflation calculations remained extremely high, so they were an attractive asset class to be in. With leveraged loans, as yields go up, their coupon payments go up as well, most of the time," he said.

The Bloomberg U.S. TIPS index returned 6% for the year and 2.4% for the quarter, and the Bloomberg U.S. Corporate High-Yield index returned 5.3% for the one-year period and 0.7% for the quarter ended Dec. 31.

The median one-year return for TIPS strategies in Morningstar's universe was 5.96%, and the median quarterly return was 2.28%; the median return for domestic high-yield strategies was 4.85% for the year and 0.67% for the quarter, and the median return for Morningstar's entire domestic fixed-income universe was 0.13% for the year and 0.1% for the quarter ended Dec. 31.

"Overall, 2021 was a very volatile year for fixed income. The first-quarter sell-off weighed down a lot of assets so even if they posted positive returns in the last quarter, still a lot of tough times for almost everybody in fixed income unless you were taking on credit risk," he said.

The Bloomberg U.S. Aggregate Bond index, which Mr. Denis said can be seen as a representation of fixed-income markets as a whole, returned 1 basis point for the quarter and posted a -1.5% return for the year. Last year was the first time the index had a negative return since 2013, he said.

"Generally speaking, it was another quarter asking what exactly is going to happen with COVID, and what exactly is going to happen with the Fed?" Mr. Denis said.

16th Amendment Advisors LLC's Vicksburg strategy once again topped both the overall domestic one- and five-year lists, with a 40.81% gross return for the year ended Dec. 31 and a gross annualized 34.7% return for the five-year period. All multiyear returns are annualized.

The Vicksburg portfolio, which is in Morningstar's U.S. municipal national long-term bond category, holds taxable and tax-exempt investment-grade municipal bonds, corporate bonds and their hedges as a total return institutional fixed-income strategy, according to the strategy's Morningstar fact sheet.

A 17.94% return put Horizon Investments LLC's active income strategy in second place for the year. The strategy is in Morningstar's non-traditional bond category, and as of Dec. 31, 42% of the portfolio's fixed-income holdings were corporate bonds, while 58% were allocated to cash and short-term equivalents, according to its fact sheet.

Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s fixed-income composite was in third place on Morningstar's one- and five-year lists, with a gross 15.24% return for the year and 10.47% return for the five years ended Dec. 31. The strategy was on Morningstar's one- and five-year top ten lists in each quarter of 2021.

Herzfeld's strategy was interest-rate and inflation sensitive throughout the second half of 2021, portfolio manager Ryan Paylor said, holding floating-rate and inflation-linked securities.

"That's what the bulk of our performance has been coming from. We made some tactical allocations to energy debt, and we've been buying some alternative credit, like closed-end funds where they're finding other ways to get income, whether it's private credit or investing in SPACs at the IPO," Mr. Paylor said.

He said closed-end funds that invest in special purpose acquisition companies have been an efficient investment for the strategy. The funds don't typically hold through the merger, he said, but rather take their profits earlier in the process. "Effectively, they're creating income by selling if they pop. And if they don't, they redeem and get the value of the underlying Treasuries," he said.

Volatility related to inflation and the ongoing impact of the COVID-19 pandemic continue to be a concern for fixed-income investors going into the first quarter of 2022, Mr. Paylor said, as well as continued low yields as the Fed looks to raise rates.

"I think investors are going to be hard-pressed to find positive returns in fixed income this year. But I do think closed-end funds provide that opportunity, as opposed to some of the traditional fixed-income instruments. Or you might need to dip into hedge funds that are actually short, mainly because I just don't see how you can make a lot of money with yields as low as they are in a rising-rate environment," he said.

The Bloomberg U.S. Aggregate Bond index finished 2021 with a negative return, Mr. Paylor said, "and even if it stops dropping and it just stays flat this year, the yield isn't going to get them back to positive and it needs positive price performance in order to be positive on the year."

A gross 12.16% return put First Trust Portfolios LP's taxable closed-end fund in fourth place, while Mesirow Financial Investment Management Inc.'s high-yield strategy rounded out the top five for the year ended Dec. 31 with a gross 12.12% return.

Long-duration bonds made up the majority of the list of top performers for the five-year period, holding six of the 10 spaces.

Pacific Investment Management Co.'s real return asset long-duration strategy was in second place among five-year returns, with a gross 10.77% for the period ended Dec. 31. PIMCO's strategy is in Morningstar's inflation-protected bond category.

Barrow, Hanley, Mewhinney & Strauss LLC's extended duration strategy held the fourth spot with a gross 9.41%, followed by Jennison Associates LLC's long conservative Treasury STRIPS strategy in fifth place with a five-year return of 9.19%. Both strategies are in Morningstar's long-duration government bond category.

High-yield and inflation-protected bonds dominated the year in Morningstar's domestic collective investment trust universe. Five of the top 10 strategies were in the inflation-protected bond category, while four were high yield.

DDJ Capital Management LLC's Total Return Credit I composite, which is in Morningstar's high-yield category, was in first place on the one-year list for the second consecutive quarter, with a net return of 8.21%.

PGIM Inc. filled the second and third spots. PGIM's Bank Loan Fund 1 was second on the list with a 6.96% return, and the High Yield Fund 1 was in third place for the year with 6.75%.

MissionSquare Investments High Yield Fund M returned 6.63%, putting it in the fourth spot, while AllianceBernstein LP's U.S. Inflation-Linked Securities Collective Trust B fund filled the fifth spot with a 6.58% return.

All 10 of the top CITs for the five years ended Dec. 31 were long-duration portfolios.

Legal & General Investment Management America Inc.'s Long Liability Treasury 2X CIT held the top spot with an annualized 10.18% net five-year return, and the firm's Treasury 15+ STRIPS CIT was in third place with 8.94% for the period.

Fidelity Institutional Asset Management's Long U.S. Treasury STRIPS Pool index fund ranked second with a net 9.43%, PGIM's U.S. Long Duration Corporate Bond 1 was fourth with 8.73%, and Wellington Management Co. LLP's CIF II U.S. Investment Grade Corporate Long Bond fund remained in fifth place for the second consecutive quarter with a net 8.14%.

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 Feb. 4.