High-yield strategies dominate Morningstar’s 1-year fixed-income rankings

High-yield strategies were the top performers in fixed income in the first quarter of 2021, according to Morningstar Inc.'s separate account/collective investment trust database. Seven of the top 10 fixed-income strategies in the separate account universe were in Morningstar's high-yield bond category for the year ended March 31, an abrupt change from the 2020 calendar year, in which long-duration bonds dominated the one-year top 10 list each quarter.

"If Q1 2020 was a textbook credit-related shock, (the first quarter of 2021) was textbook interest-rate-related shock," said Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago.

Mr. Denis said concerns about inflation returned in the first quarter of 2021 as the Federal Reserve kept rates steady during the quarter ended March 31 and did not move towards a rate-hike cycle, following last August's policy change in which the Fed said it would target an average, over time, of 2% inflation.

Mr. Denis said the Fed signaled that they would have to see a sustained period of inflation before moving toward rate hikes. He also said the Fed announced the decision in the first quarter of 2021 to keep rates close to zero and said their current outlook is that any inflation will be transitory.

The first quarter also saw large government spending packages from the Biden administration, with the third stimulus bill passing at the beginning of March followed by the announcement of a large infrastructure bill at the end of the month. Mr. Denis said the combination of government spending, across the economy, and the lack of rate hikes contributed to the return of a risk-on sentiment in fixed-income markets.

"You see a lot of market participants start to fear this return of inflation, which we haven't seen for a very long time. In addition to that, there is this optimism around the fact that the vaccine rollout is proceeding, and we're starting to see more and more people return to 'normalcy' with work and with play, in terms of going out to restaurants, and all of that together leads to this big risk-on move," Mr. Denis said.

He said the long end of the Treasury curve "was the worst performing amongst the fixed-income assets that we track" during the first quarter of 2021 and that investment-grade corporate bonds and agency mortgages also experienced a performance drop during the quarter.

"We saw resilience among assets that have a little bit more credit risk involved," he said. High-yield corporate bonds, bank loans, and high-yield municipals performed well, Mr. Denis said.

"This was the textbook interest-rate shock, where investor anticipation of rising yields contributed to underperformance among the higher-quality and longer-duration fare. Both shorter-duration securities and those with higher yields, and thus more credit risk, tend to outperform in these environments," he said.

For the year ended March 31, the median one-year return for domestic high-yield strategies in Morningstar's universe was 21.98%, the median return for Morningstar's entire domestic fixed-income universe was 4.83% and the median return for long-duration domestic strategies in Morningstar's universe was 3.26%.

At the same time, the Bloomberg Barclays U.S. Corporate High-Yield index, returned 23.7% for the one-year period ended March 31; the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 7.1%; the Bloomberg Barclays U.S. Aggregate Bond index had a one-year return of 0.7%; and the Bloomberg Barclays U.S. Long Government/Credit index returned -2.1%.

New York-based 16th Amendment Advisors LLC's Vicksburg strategy topped both the one- and five-year lists, with a 119.87% gross return for the year ended March 31 and a gross annualized 35.2% return for the five-year period. All multi-year returns are annualized.

The Vicksburg strategy, which is in Morningstar's U.S. municipal national long-term bond category, has led the one-year list since the second quarter of 2020, and the strategy has been at the top of the five-year list since the first quarter of 2020.

The Bloomberg Barclays U.S. Municipal bond index, by comparison, returned 5.5% for the one-year period ended March 31 and an annualized 3.5% for the five year period. A 16th Amendment official could not be reached for comment by press time.

The Short-Duration High Yield strategy from L&S Advisors Inc. was in second place on Morningstar's list with a 44.49% return for the year ended March 31. The strategy invests in corporate bonds that are rated below BBB or Baa by the major bond rating agencies.

Mellon Investment Management's U.S. Fallen Angels Beta Plus composite was third on the list of top performers, with a gross return of 42.7% for the year ended March 31.

Paul Benson, the San Francisco-based head of fixed income efficient beta and the portfolio manager of Mellon's fallen angels strategy said, "We come across a few very significant misconceptions about fallen angels and I suppose that probably has something to do with this ominous name that it has."

Mr. Benson said some investors may see fallen angels as "companies that are in free fall and are about to implode" but on an annual average over the last 15 years, fallen angels had a default rate of only about 0.6% and tend to have about one-third of the default risk of securities in the broad high-yield index.

"If you consider the risk premium that you're being compensated for, it almost puts (fallen angels) in the category of investment grade, in the BBB area." Mr. Benson said fallen angels have most often been "downgraded from the BBB notch to BB, and then they enter the fallen angel and the high-yield universes."

Mellon's fallen angels composite only invests in bonds within the Bloomberg Barclays U.S. High Yield Fallen Angels 3% Cap index, which returned 39.6% for the year ended March 31, and about 90% of the portfolio is comprised of BB-rated issues.

In a low-yield environment, exacerbated by coordinated central bank action on both the monetary and fiscal stimulus sides, investors are hunting for yield, Mr. Benson said, and fallen angels can provide opportunities for companies that are derisking from equities, or can complement or replace traditional high-yield investments.

"In good years for fallen angels, we've seen fallen angels outperform broad high yield by 5, 10, 15%. And in quiet years for fallen angels, where downgrades are muted, we've seen fallen angels outperform high yield by about 1%, on average. But it very rarely underperforms broad high yield," he said.

On a five-year rolling return horizon, since the inception of the fallen angel index in 2005, Mr. Benson said the index has never underperformed the broad high-yield index.

Mellon's approach as a research-driven, quantitative, pure-play manager in the high-yield space was an advantage at the peak of the crisis period in the spring of 2020 because the portfolio managers were able to efficiently trade during the peak of market illiquidity, he said.

"We have been one of the pioneers in credit portfolio trading (in which a large number of bonds are traded as a single basket), and so credit portfolio trading really was a fantastic tool for us to access liquidity during this unique time when liquidity in the over-the-counter markets just was not there," Mr. Benson said. Managers of the fallen angels composite were able to mitigate the performance drag of illiquidity and high transaction costs "very significantly, through our innovation, mostly on the technological side with portfolio credit trading," Mr. Benson said.

Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s Fixed Income composite was in fourth place on both the one- and five-year lists with a 41.3% return for the one-year period ended March 31 and an annualized 11.28% five-year return. The strategy is in Morningstar's multisector bond category.

Ryan Paylor, a portfolio manager on Herzfeld's fixed-income composite, said the portfolio was overweight investment-grade holdings in early 2020, in response to the spread of COVID-19 into Europe, relative to its historical position. Mr. Paylor said the onset of the COVID-19 crisis in the United States brought opportunities in the CCC to BB+ range.

"We were able to rebalance our portfolio from overweight investment-grade closed-end funds to non-investment grade by purchasing bank loan and high-yield closed-end funds at fire-sale prices. There were some investment-grade closed-end funds that we still liked because they went to significantly wide discounts. We were seeing discounts in excess of 20-plus percent in the closed end fund space," Mr. Paylor said.

The portfolio benefited from the price appreciation of the discounted assets, as well as the U.S. federal government and the Federal Reserve's work to proactively support the economy, he said.

"For the better part of the last year, we were able to take advantage of the demand for yield and because the Fed was backstopping everything, and the government was doing PPP loans and sending out checks, we were able to kind of hold on to the riskier credit, knowing that there was a backstop temporarily in the market," he said.

In the first quarter of 2021, Mr. Paylor said more bank loans and collateralized loan obligations were added to the portfolio as the vaccine rollout is projected to minimize defaults.

"Those are areas that we think will benefit from a rising rate environment," he said. "We think we're well positioned, in our current holdings, to take advantage of future volatility as the portfolio is well-diversified. One of the interesting things about our portfolio is we've been relatively very short duration throughout the entire period. And one of the things that we decided is we didn't want significant exposure to the potential for higher rates, whether it's due to inflation, a growing economy, or a combination thereof."

Toews Asset Management's All Equity Legacy strategy rounded out the top five for the one-year period with a 39.86% return. The portfolio has an average credit quality of AA and is in Morningstar's intermediate core bond category.

The Select Credit Opportunities composite, a high-yield strategy from MacKay Shields LLC, was in second place for the five-year period, with an annualized 11.78% return.

An annualized 11.45% return put Diamond Hill Capital Management Inc.'s High Yield strategy in third place among the five-year returns and Artisan Partners' High Income strategy rounded out the five-year list with an annualized 10.26% return.

By comparison, the Bloomberg Barclays U.S. Corporate High-Yield index returned 8.1% for the five-year period ended March 31; the Bloomberg Barclays U.S. Long Government/Credit index returned an annualized 5.5%; the Bloomberg Barclays U.S. Aggregate Bond index had an annualized five-year return of 3.1%; and the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 2.1% for the five years ended March 31.

For the five years ended March 31, the median annualized return for domestic high-yield strategies in Morningstar's universe was 7.44%, the median return for long-duration domestic strategies was an annualized 6.14% and the median annualized five-year return for Morningstar's entire domestic fixed-income universe was 3.66% for the period ended March 31.

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 March 31, holding all of the top 10 spots for the year and nine of the 10 spots on the five-year list. In the last quarter of 2020, long-duration strategies held eight of the top 10 spots on each list.

The BNY Mellon DB NSL Efficient Beta Fallen Angels fund led the CIT list with a net return of 42.24%.

This fallen angels CIT fund is the strategy managed by Mellon's Mr. Benson and his team, in a different vehicle wrapper.

"I think there are a lot of investors who are realizing that (the fallen angels strategy) is an investment that can be a core part of their asset allocation," Mr. Benson said.

Mesirow Financial's High Yield CIT was in second place with a net return of 38.02%; followed by Shenkman Capital Management Inc.'s Four Points Multi-Strategy fund, with a net 29.67% for the year.

The Shenkman strategy appeared first on the five-year CIT list with a net annualized 8.82% for the five years ended March 31.

A 29.06% return for Northern Trust Asset Management's High Yield Fixed Income fund put it in fourth place on the one-year list, while an annualized net 7.76% return put it in fifth place for the five years ended March 31.

DDJ Capital Management LLC's Total Return Credit I composite rounded out the one-year top-five list with a net 27.99% return and was second on the five-year list with a net annualized 8.82% return for the period.

Prudential Financial Inc.'s High Yield Fund 1 had the third-highest annualized return of 8.3% for the five-year period, and BNY Mellon's DB SL High Yield Beta fund completed the CIT list, in fourth place with an annualized 8.06% return for the five years ended March 31.

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 May 4.