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  2. Special Report: Top-Performing Managers
November 29, 2021 12:00 AM

High yield, TIPS strategies find success amid flat bond markets

Trilbe Wynne
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    Jed McCarthy

    16th Amendment Advisors' R. Jed McCarthy

    High yield held the majority of spots among the top-performing fixed-income strategies for the year ended Sept. 30, according to Morningstar Inc.'s separate account/collective investment trust database. Six of the top 10 fixed-income strategies in the separate account universe were in Morningstar's high-yield bond category, down from nine strategies in the one-year period ended June 30.

    Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago, said during the third quarter, market observers were waiting and watching the progress of the U.S. infrastructure bill, the state of global supply chains and the rate of U.S. spending, as debates continued over whether inflation would be a short- or long-term phenomenon.

    U.S. Treasury inflation-protected securities were among the winners in the third quarter, Mr. Denis said, as TIPS tend to perform better when inflation expectations are higher. And as more investors became concerned that inflation would be longer term, there was higher demand, which led to a better quarter for TIPS, he said.

    The Bloomberg U.S. TIPS index returned 5.19% for the year ended Sept. 30.

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    Mr. Denis said the Bloomberg U.S. Aggregate Bond index, which can be seen as a representation of fixed-income markets as a whole, only returned 5 basis points during the third quarter, bringing its return for the first three quarters of 2021 to -1.6%. The 10-year U.S. Treasury, which is often used as a bellwether for inflation, was volatile, with its yield rising modestly toward the end of September, he said

    Riskier assets, such as high yield and leveraged loans, performed well in the third quarter, Mr. Denis added. "This was mostly based off of continuing optimism that we were potentially going to see stronger economic growth, but with that asterisk of, or with the addition of inflation and other uncertainties," he said.

    Energy producers have been struggling over the past few years, Mr. Denis said, with lower oil and natural gas prices. So the rise in energy prices during the third quarter also contributed to better performance for high-yield fixed income, he said.

    "There has been a knock-on effect in high yield," Mr. Denis said, "Generally, (energy producers) are a bigger part of the index and so those types of themes are going to do better in this type of environment."

    The Bloomberg U.S. Corporate High-Yield index returned 11.3% for the one-year period ended Sept. 30, while the Bloomberg U.S. Aggregate Bond index returned 0.9% and the Bloomberg Global Aggregate ex-U.S. Bond index had a one-year return of -1.2%.

    The median one-year return for domestic high-yield strategies in Morningstar's universe was 10.38%, and the median return for Morningstar's entire domestic fixed-income universe was 1.53% for the year ended Sept. 30.

    New York-based 16th Amendment Advisors LLC's Vicksburg strategy topped both the overall one- and five-year lists, with a 57.51% gross return for the year ended Sept. 30 and a gross annualized 31.96% return for the five-year period. All multiyear returns are annualized.

    The top-performing fixed income managers for Q3 2021
    Overall U.S. fixed income separate accounts: one year
    RankFundCategoryGross returnNet
    return
    116th Amendment VicksburgU.S. SA muni national long57.51%48.97%
    2Herzfeld Fixed Income CompositeU.S. SA multisector bond24.11%23.10%
    3L&S Short-Duration High YieldU.S. SA high-yield bond23.95%22.84%
    4First Trust Taxable Closed End FundU.S. SA high-yield bond23.53%21.91%
    5L&S High YieldU.S. SA multisector bond19.49%18.52%
    6Strategic Income Mmgt SiM High Yld InstlU.S. SA high-yield bond18.05%17.63%
    7Toews All Equity LegacyU.S. SA short-term bond17.66%16.27%
    8DDJ U.S. Opportunistic High Yield CompU.S. SA high-yield bond17.37%16.82%
    9MacKay Select Credit Opportunities CompU.S. SA high-yield bond16.90%16.04%
    10Federated Hermes Opportunistic HighYieldU.S. SA high-yield bond16.62%16.04%
    Overall U.S. fixed income separate accounts: five years
    RankFundCategoryGross returnNet
    return
    116th Amendment VicksburgU.S. SA muni national long31.96%24.44%
    2Herzfeld Fixed Income CompositeU.S. SA multisector bond10.52%9.69%
    3MacKay Select Credit Opportunities CompU.S. SA high-yield bond9.05%8.30%
    4First Trust Taxable Closed End FundU.S. SA high-yield bond8.20%6.75%
    5Toews All Equity LegacyU.S. SA short-term bond8.19%6.76%
    6Shenkman Capital Multi-Strategy CompU.S. SA high-yield bond8.19%7.38%
    7Strategic Income Mmgt SiM High Yld InstlU.S. SA high-yield bond8.18%7.77%
    8PIMCO Real Ret Asset Long DurationU.S. SA inflation-protected bond8.07%7.51%
    9DDJ U.S. Opportunistic High Yield CompU.S. SA high-yield bond8.03%7.55%
    10T. Rowe Price US High Yield Bd (Phila.)U.S. SA high-yield bond7.88%7.35%
    Overall U.S. fixed income CITs: one year
    RankFundCategoryGross returnNet
    return
    1DDJ Total Return Credit I CompositeU.S. SA high-yield bond17.03%16.12%
    2MissionSquare High Yield Fund MU.S. SA high-yield bond 12.76%
    3MissionSquare High Yield S2U.S. SA high-yield bond 12.08%
    4Loomis Sayles High Yield Consrv Tr CU.S. SA high-yield bond 12.06%
    5Prudential High Yield Fund 1U.S. SA high-yield bond 11.91%
    6Shenkman Capital Four Pts Multi-Strat FdU.S. SA high-yield bond12.60%11.62%
    7BNYM Insight DB SL High Yield Beta FundU.S. SA high-yield bond11.69%11.43%
    8Prudential Bank Loan Fund 1U.S. SA bank loan 11.27%
    9T. Rowe Price High Yield Tr-ZU.S. SA high-yield bond 11.04%
    10MacKay Shields High Yld Bond CIT Class 1U.S. SA high-yield bond11.24%10.85%
    Overall U.S. fixed income CITs: five years
    RankFundCategoryGross returnNet
    return
    1Prudential High Yield Fund 1U.S. SA high-yield bond 7.46%
    2Shenkman Capital Four Pts Multi-StratU.S. SA high-yield bond8.20%7.25%
    3Prudential US Long Dur Corp Bond 1U.S. SA long-term bond 7.24%
    4DDJ Total Return Credit I CompositeU.S. SA high-yield bond8.17%7.17%
    5Wellington CIF II US Inv Grd Corp Lng BdU.S. SA corporate bond 6.81%
    6BNYM Insight DB SL High Yield Beta FundU.S. SA high-yield bond6.92%6.66%
    7Legal & General Long Dur US Credit CITU.S. SA long-term bond 6.57%
    8MissionSquare High Yield Fund MU.S. SA high-yield bond 6.51%
    9T. Rowe Price High Yield Tr-ZU.S. SA high-yield bond 6.40%
    10State St. US Lg Cred Bnd Indx NL Cl AU.S. SA long-term bond 6.28%

    Vicksburg is a total return, institutional fixed-income strategy, said John J. Lee, a co-founder and managing member. The portfolio holds investment-grade municipal bonds, corporate bonds and their hedges, he said, in a strategy that is targeted to investors looking for non-correlated high-grade fixed-income exposure.

    U.S. tax-exempt investors, such as pension funds and foundations, have historically overlooked strategies with municipal bonds, Mr. Lee said, assuming such strategies were designed solely for U.S. retail investors.

    "The fact that the underlying assets happen to be municipal bonds, that the coupons are often tax-exempt to a U.S. taxable investor, that's sort of an artifact and it's not necessarily relevant to what the return profile is of the strategy because we're engaged in relative-value trading. We're not necessarily trying to collect the interest income, although that's a nice added benefit," Mr. Lee said.

    Security selection, the use of leverage and hedging the portfolio's exposures are areas of expertise for the portfolio managers, and that expertise has contributed to the strategy's performance, Mr. Lee said.

    "All three of those play a very important role in the structuring of trades that go in the portfolio. And that's the element that differentiates the strategy from cash-on-cash, long-only trading," Mr. Lee said.

    As institutional managers engaged in relative-value trading in a space that primarily feeds the retail market, Vicksburg's portfolio managers have been able to take advantage of their niche understanding of a large and fragmented market, said R. Jed McCarthy, a co-founder, managing member and portfolio manager. Opportunities arose from varying spreads during the past year, he said, as many bonds that had reliably traded within a narrow range for many years became more volatile during the crisis period that followed the onset of the COVID-19 pandemic.

    "That had the effect of a lot of broker-dealers pulling back their horns as far as taking risk, and general bid-offer spreads increased during that period of time. The market, since then, has calmed down. But through this past year, I think we've benefited from the fact that the risk-off environment still persists. So that was a big factor."

    Mr. McCarthy sees continued opportunities in the tax-exempt municipal market. "There's less capital that's being employed in the space. Broker-dealer inventories are still a fraction of what they were pre-pandemic. So we're very optimistic going forward," he said.

    The Bloomberg U.S. Municipal index returned 2.6% for the year ended Sept. 30 and 3.3% for the five-year period.

    Miami Beach, Fla.-based Thomas J. Herzfeld Advisors Inc.'s Fixed Income composite was in second place on both the one- and five-year lists, with a gross 24.11% return for the year and a gross 10.52% return for the five years ended Sept. 30.

    The strategy, which is in Morningstar's multisector bond category, was overweight closed-end funds with significant allocations to collateralized loan obligations during the period, portfolio manager Ryan Paylor said.

    "Being able to invest in floating-rate CLO equity has been really beneficial because the yields are significantly higher and the default risk has been relatively negated by the Fed's activity," he said.

    Mr. Paylor said the strategy was underweight "traditional fixed income" through the third quarter, such as Treasuries and investment-grade credit, but the portfolio managers have seen some recent opportunities in investment-grade bonds.

    "Still, we're leaning more toward floating-rate securities as opposed to fixed-rate because, if rates go higher, (fixed-rate securities) don't usually perform as well. With rates where they're at right now, we feel the risk is to rates going higher vs. rates going lower," Mr. Paylor said.

    In the third quarter, the strategy held more cash than it typically holds, he said, while taking a short position on long rates as a hedge. The strategy was positioned for an increase in rates on the longer end of the curve, 10 years or longer, which could come with a rise in inflation.

    "In the third quarter, we didn't see much of (an interest-rate) move necessarily warrant our positioning but we're starting to see that now. We're starting to see interest rates move back up. We're still seeing inflation elevated and the positioning that we put on early, the second quarter going into the third, now it's starting to bear fruit for us in the fourth quarter," Mr. Paylor said.

    Corporate actions that affected some of the portfolio's holdings also benefited the strategy, he said, as well as some diversification in the strategy's closed-end fund holdings.

    "Some of these funds are taking advantage of more alternative income, whether it's private credit, direct lending and the like, that we think is a slightly better investment in the current environment than trying to make a decision on which way you think Treasuries are going to go," Mr. Paylor said.

    Two strategies from Los Angeles-based L&S Advisors Inc. were among Morningstar's top five. The Short-Duration High-Yield strategy, which has a maximum five-year maturity on a rolling basis, was in third place with a gross 23.95% for the year, and the High-Yield strategy, which has a maximum 10-year maturity on a rolling basis, was in fifth place with a gross 19.49% return.

    Matthew Nussbaum, a portfolio manager and senior analyst, said both strategies look for value in broken convertibles from smaller-cap issuers and smaller issue sizes, specifically buying the convertibles to hold as bonds rather than buying the securities in order to eventually convert them to equity.

    "We think that's an area where there are more inefficiencies, where fundamental analysis can really add value. Also in the high-yield space, we believe there is not a lot of representation, generally, in technology or health care. So we seek to find, on a relative-value basis, really good value in convertibles," Mr. Nussbaum said.

    By participating in what they believe to be less-efficient markets, Mr. Nussbaum said the portfolio managers look for opportunities that might be overlooked by larger high-yield managers because a small issue size could preclude a larger manager from participating.

    In addition to health care and technology, Kenneth Malamed, a senior managing director at L&S, said the strategies also sought to find value in the secondary energy space during the third quarter, finding firms with rapidly improving balance sheets.

    "In some cases, we observed their stocks were doing exceptionally well. But more importantly, they're producing yield. That continued through the third quarter and added to performance," Mr. Malamed said.

    First Trust Portfolios LP's Taxable Closed-End fund rounded out the top five for the year ended Sept. 30 with a gross 23.53% return. The First Trust strategy was also on the five-year list, in fourth place with a return of 8.2%.

    Rounding out the top five on the five-year list was MacKay Shields LLC's Select Credit Opportunities composite in third place and Toews Corp.'s All Equity Legacy strategy in fifth place. According to a Morningstar fact sheet, the portfolio is made up of 75% bonds and 25% cash. The MacKay Shields strategy had a 9.05% five-year return, and the Toews strategy returned 8.19% for the period.

    The Bloomberg U.S. Corporate High-Yield index returned 6.5% for the five years ended Sept. 30, while the Bloomberg U.S. Aggregate Bond index returned 2.9%, and the Bloomberg Global Aggregate ex-U.S. Bond index had a five-year return of 1.1%.

    The median five-year return for domestic high-yield strategies in Morningstar's universe was 6.33% and the median return for Morningstar's entire domestic fixed-income universe was 3.32%

    High-yield strategies were still in the majority among five-year returns, but high-yield held only six of the top 10 spots as of Sept. 30, down from nine at the end of June.

    Bloomberg
    High yield also leads CITs

    High-yield portfolios also came out on top in Morningstar's domestic collective investment trust universe for the one- and five-year periods ended Sept. 30. High yield held nine of the top 10 spots for the year, down from all 10 spots at the end of the previous quarter, and held six of the 10 spots on the five-year list, falling from eight in the second quarter.

    DDJ Capital Management LLC's Total Return Credit I composite moved into first place on the one-year list with a net return of 16.12%, up from second place at the end of the previous quarter, while the strategy's 7.17% return put it in fourth place on the five-year list.

    Strategies from MissionSquare Investments filled the second and third spots for the year. MissionSquare's High Yield Fund M returned 12.76%, while the firm's High Yield S2 portfolio was in third place with a 12.08% return for the year ended Sept. 30.

    Loomis, Sayles & Co. LP's High Yield Conservative Trust C was in fourth place with a 12.06% return.

    Prudential Financial Inc.'s High Yield Fund 1 was in fifth place for the year, returning 11.91%, while the strategy led the five-year period with a 7.46% return. Prudential's U.S. Long-Duration Corporate Bond 1 portfolio ranked third for the five-year period with a 7.24% return.

    Shenkman Capital Management Inc.'s Four Points Multi-Strategy fund dropped to second place for the five-year period ended Sept. 30, down from first place in the previous quarter, with a net 7.25% return. Meanwhile, Wellington Management Co. LLP's CIF II U.S. Investment Grade Corporate Long Bond fund rose to fifth place from seventh place on Morningstar's five-year list with a 6.81% return for the period ended Sept. 30.

    For the year ended Sept. 30, the median one-year return for domestic high-yield strategies in Morningstar's CIT universe was 11.23%, and the median return for overall domestic fixed-income CITs was 0.53%.The median five-year return was 6.29% for domestic high-yield CITs and 3.63% for Morningstar's overall universe of domestic fixed-income CITs.

    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 Nov. 4.

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