Thomas J. Herzfeld Advisors Inc.'s fixed-income composite was once again in second place on Morningstar's five-year list with a gross 8.06% return for the five years ended June 30, and the firm's tax-exempt composite was in fifth place for the period with a gross 5.05% return.
In previous quarters, with a steep yield curve and low default rates, the fixed-income composite reaped higher rewards from holding higher-yielding lower-rated credit, but the portfolio managers increased the strategy's duration and raised the credit quality in the second quarter of 2022 as the yield curve began to invert, said Erik Herzfeld, the Miami Beach, Fla.-based president and portfolio manager.
"Towards the end of the second quarter, we started swapping lower-rated credit for higher-rated, longer-dated investment-grade corporate paper and that's basically because we had a major duration sell-off and it just seemed a little bit overdone to us," he said.
Credit defaults have remained low but Mr. Herzfeld said market conditions look to be changing as the Fed looks to contain inflation, which could lead to an increase in default rates as borrowing costs increase.
Herzfeld's high-yield fixed-income composite took advantage of opportunities in discounted closed-end funds in previous quarters but Mr. Herzfeld said the portfolio moved away from funds that rely on leverage in that space in the second quarter, as the flattening yield curve and the increased cost of leverage reduced some of the benefits.
"Previously, with a steep yield curve, closed-end funds could borrow very, very cheaply and reinvest into higher-yielding assets. Now, with the curve the way it is, it just doesn't work anymore," he said. "Especially with this inversion. If you look at borrowing rates, it just gets very expensive to make leverage work in the closed-end fund space."
Mr. Herzfeld said he's seeing opportunities such as collateralized loan obligations that are yielding 200 to 220 basis points over the secured overnight financing rate for the AAA tranche. "We used to have to take a lot more credit risk to get the same yield. Thanks to the Fed, you can get a lot more reward by simply being in higher (rated) credit," he said.
A gross 5.25% return put Nasdaq's Dorsey Wright tactical fixed-income strategy in third place for the five-year period, while a gross 5.1% placed Franklin Templeton's U.S. TIPS composite in fourth place over the same period.
The Bloomberg U.S. TIPS index returned 3.2% for the five-year period; the Bloomberg U.S. Corporate High-Yield index, 2.1%; the Bloomberg U.S. Corporate Bond index 1.3%; the Bloomberg Short-Duration 1-3 Year Treasury index and the Bloomberg U.S. Aggregate Bond index each returned 0.9%; and the Bloomberg U.S. Long Treasury index, 0.5%.
The median five-year return for Morningstar's entire domestic fixed-income universe was 1.56% for the period ended June 30.