Return of risk puts high yield on par with long duration

Long-duration bonds continued to dominate the list of top-performing fixed-income strategies in the last quarter of 2020, once again claiming nine of the top 10 spots, according to Morningstar Inc.'s separate account/collective investment trust database, but the return of a risk-on sentiment in the fourth quarter led to strong returns among high-yield municipal and corporate bonds.

"The fourth quarter was the culmination of a lot of the optimism that was starting to bubble through in the third quarter. Really, the two biggest pieces of optimism for a lot of investors at that point kind of came true," said Gabriel Denis, an analyst for fixed-income strategies at Morningstar in Chicago.

Mr. Denis said election results signaled the direction of U.S. policy regarding taxes and regulation, relieving some political uncertainty, and the anticipated COVID-19 vaccines became ready for distribution toward the end of the fourth quarter.

"As conditions changed and a risk-on sentiment returned, high-yield municipal and corporate bonds rallied in the fourth quarter," Mr. Denis said. "Among the biggest winners of the quarter were emerging market sovereign bonds issued in local currencies."

The J.P. Morgan Government Bond Index-Emerging Markets Global Diversified benchmark, which tracks a broad basket of these bonds, posted a 9.6% return for the quarter ended Dec. 31, he said.

Despite losing some ground in the fourth quarter, U.S. Treasuries performed well year over year and posted a positive return for 2020 largely due to the strength of the first quarter's risk-off rally that benefited long-duration bonds, Mr. Denis said.

Long-duration U.S. government bond strategies continued to dominate Morningstar's list but dropped to five of the 10 best performers at the end of 2020, down from seven out of 10 for the year ended Sept. 30.

"One of the things that people had been watching throughout this quarter was the U.S. dollar, which had been so strong when everyone was running to the safety of U.S. Treasuries and the safety of the U.S. dollar. We saw a lot of global currency post big losses against the dollar earlier in the year. The inverse happened (in the fourth quarter) so the dollar depreciated in value and there was a lot more optimism around the potential for global growth to outstrip U.S. growth," Mr. Denis said.

The Bloomberg Barclays U.S. Long-Government Bond index returned 17.55% for the year ended Dec. 31; the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 10.11% for the year; and the Bloomberg Barclays U.S. Aggregate Bond index had a one-year return of 7.51%.

"In fact, almost every single fixed-income asset that we monitor in these broad benchmarks did post a positive return. There were few 'losers,' but some returned less because they had so much catch-up to play after their poor returns over the year," he said.

Generally speaking, he said, the final quarter of 2020 saw the completion of a "V-shaped recovery" for the markets. "So, despite those huge losses in the beginning of the year, a lot of people ended up in the green at the end of the year." Investment-grade and high-yield bond spreads resembled an "inverse V" in 2020, he said, rising from low levels at the end of 2019 to some of the highest levels bond markets have experienced in some time, driven by the onset of the pandemic in March, before returning to their previously low levels in the fourth quarter.

"While they haven't quite reached their 2019 low, a lot of those areas have reached close to that low. So it's almost as if the crisis that we saw back in March has faded into recent memory, with a lot of corporate assets posting some of the lowest yields they've ever posted," he said.

For the year ended Dec. 31, the median one-year return for long-duration domestic strategies in Morningstar's universe was 16.83%, the median return for domestic high-yield strategies was 6.85% and the median return for Morningstar's entire domestic fixed-income universe was 6.44%.

New York-based 16th Amendment Advisors LLC's Vicksburg strategy once again topped both the one- and five-year lists, with a 67.98% gross return for the year and a gross annualized 35.81% return for the five-year period ended Dec. 31. All multiyear returns are annualized.

This is the third consecutive quarter the Vicksburg strategy, which is in Morningstar's U.S. municipal national long-term bond category, has topped the one-year list and the strategy led the five-year list in all four quarters of 2020.

Pacific Investment Management Co. had two strategies among the top five. The Real Return Asset Long Duration strategy, which is in Morningstar's inflation-protected bond category, was in second place on the list for the second consecutive quarter with a gross 27.83% return. PIMCO's Long Bond Extended Duration strategy rose to fourth place from seventh with a gross return of 23.28% for the year ended Dec. 31, and remained in second place for the five-year period with a gross 11.97% return.

The extended duration bond strategy from Barrow, Hanley, Mewhinney & Strauss LLC was third on the list of top performers, with a gross return of 23.82% for the year ended Dec. 31 and the firm's long government/credit strategy was in sixth place with a gross 22.36% return.

Scott McDonald, a Dallas-based managing director and fixed-income portfolio manager at Barrow Hanley, said the extended duration bond strategy is actively managed against the Bloomberg Barclays STRIPS 20+ index, purchasing STRIPS — zero-coupon bonds — that have a duration of 20 years or longer.

"There are anomalies or opportunities within that longer part of the STRIPS curve that create opportunities for an active manager to take advantage of," Mr. McDonald said.

He said opportunities arise as STRIPS are created or reconstituted from the underlying U.S. Treasury bonds. "And either that demand or oversupply creates short-term opportunities that we, as an active manager, take advantage of. So the large driver of returns was the decline in Treasury rates. Specifically, the 30-year Treasury rate, which declined from 239 at the beginning of last year to 165. So about a 74-basis-point decline," Mr. McDonald said.

He said the decline in U.S. Treasury rates, driven by the economic impact of the COVID-19 crisis, was the largest contributor to returns for both Barrow Hanley strategies on Morningstar's list.

Mr. McDonald said there was a global move toward safety in fixed-income markets during the crisis period in 2020. "That move toward safety is generally a move toward U.S. Treasuries and both of these strategies benefited from that move."

Barrow Hanley's long government/credit portfolio holds a combination of long-duration U.S. Treasury bonds and long-duration corporate bonds.

"We came into the year, in that strategy, neutral in our exposure to credit or derisked from a historical perspective due to valuations in the credit market that were through their long-term averages, which is the first step in how we look at valuation," Mr. McDonald said. "And because of that derisked position, we were able to take advantage of adding credit exposure in March during the peak of the havoc in the markets."

Mr. McDonald said being opportunistic, along with the derisked position at the beginning of the year, allowed portfolio managers to add value during both the spread-widening period in March and the spread-tightening period from March through the end of the year by moving the portfolio toward an overweight in credit.

"We were able to add to credit exposure in March and because of that add to credit exposure, we then benefited from the tightening as credit spreads moved from their wides at the end of March to a level that really was in line with credit spreads at the beginning of the year," he said.

Mr. McDonald said both the extended duration and long government/credit strategies "help our clients manage the liability side of their defined benefit plans. So we use this in constitution with other credit strategies that help them fine-tune the risk profiles or hedge ratios that they want to use in terms of managing against their liabilities."

NISA Investment Advisors LLC's 15+ STRIPS fixed-income composite rounds out the top five among one-year returns with 23.25%, moving down one spot from fourth place at the end of the previous quarter.

For the five-year period, MetLife Investment Management's Long Credit strategy moved up two spots into third place on the list, with a gross return of 11.95%.

Diamond Hill Capital Management Inc.'s high-yield strategy entered the list in fourth place with an 11.67% return and PIMCO's Long Term Bond – Long Credit strategy rounds out the five-year list with an 11.63% gross return.

The Bloomberg Barclays U.S. Long-Government Bond index returned an annualized 7.83% for the five years ended Dec. 31; the Bloomberg Barclays Global Aggregate ex-U.S. Bond index returned 4.89% for the period; and the Bloomberg Barclays U.S. Aggregate Bond index had a five-year return of 4.43%.

Long-duration fixed-income strategies also came out on top on Morningstar's domestic collective investment trust universe for the one- and five-year periods ended Dec. 31, holding eight of the top 10 spots on both lists. In the previous quarter, all of the top 10 funds on both lists were long-duration bond portfolios.

Legal & General Investment Management America Inc. held the top two spots on the list of one-year CIT returns. The Legal & General Long Liability Treasury 2X CIT led with a net 29.32% return, while a 25.44% return put the Long Liability Treasury 3X CIT in second place for the year.

Fidelity Institutional Asset Management's Long U.S. Treasury STRIPS Pool index fund ranked third with a net 24.45% and held the second spot among five-year returns with a net annualized 10.91%.

For the five-year period, a net return of 11.03% put Prudential Financial Inc.'s U.S. Long Duration Corporate Bond 1 fund on top, with Prudential's Long Duration Corporate Bond 3 in fourth place with 10.72% and the Long Duration Corporate Bond 4 was fifth on the list with a net 10.61%.

Wellington's CIF II U.S. Investment Grade Corporate Long Bond fund rounds out the five-year list in third place with a 10.88% net return for the period ended Dec. 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 Feb. 3.