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.