The credit crunch is separating the men from the boys in core fixed-income portfolios.
Mispricing of fixed-income securities is creating huge opportunities for bond managers. Some are finding gems in high-grade corporate bonds, mortgage-backed securities and municipal bonds.
Andrew Phillips, managing director and co-head of U.S. fixed income of BlackRock Inc., New York, noted that high-grade corporate bonds have “unprecedented” spreads over Treasuries. The Lehman Brothers U.S. Corporate AAA bond index had a current yield as of March 13 of 4.59%, compared with the 10-year Treasury bond which yielded 3.53%.
“When Citi is cheaper than Colombia, which is on the verge of a war, it wakes you up,” Mr. Phillips said. BlackRock manages $131 billion in core fixed income strategies.
Upheaval in the credit markets already has widened the historically narrow spreads between top-quartile and bottom-quartile core fixed-income managers to a six-year high, and a liquidity crunch has forced hedge funds and financial institutions to sell off high-quality bonds, pushing yields up on those securities.
According to eVestment Alliance, Marietta, Ga., the 25th percentile manager returned 6.19% — 138 basis points higher than the 75th percentile manager in the second half of 2007. That's 306% bigger than the 34 basis-point spread between the top-quartile and bottom-quartile core fixed-income manager recorded during the first half of last year, when the top-quartile manager returned 1.23%.A table listing some of the highest and lowest performing managers during the last half of 2007 can be found at pionline.com/high-low.
Credit-market dislocations are creating enormous opportunities for managers willing to take bets on battered bonds.
No Treasuries in this portfolio - for the first time ever
Explained Jonathan Longley, portfolio manager and co-head of fixed income for Jennison Associates LLC in the firm's Waltham, Mass., office: “For the first time in the history of our core product we have almost no Treasuries because so many other sectors are attractive and you can get high-quality stuff that will pay you back.”
Jennison's active core strategy returned 7.16% in the latter half of 2007, putting it in the top 5% in eVestment Alliance's core fixed-income database.
A substantial bet on the yield curve steepening boosted performance by about 75 to 80 basis points during the second half of 2007, Mr. Longley said. The firm has taken that bet off now.
Mr. Longley said Jennison has concentrated its core portfolio on corporate bonds with a BB rating or greater. “We're overweight all the high-quality bonds,” he said. The firm has $20 billion in fixed income assets.
“Some of the industrials have gotten pretty attractive, especially in the new issue market,” Mr. Longley added. “You've got a lot of high quality names that don't have any financial (industry) exposure.”
American Century Investments' core fixed income strategy has been long on two-year futures and short on 30-year futures, said David MacEwen, chief investment officer of American Century's fixed income group in Mountain View, Calif. The group manages $20 billion in core fixed income; the strategy returned 7.17% for the last six months of 2007.
“We still think the credit environment we're in will get worse. We've seen leverage unwinding but we haven't seen the traditional economic cycle take it's course on the credit markets.”
Mr. MacEwen said American Century is also underweight financials and overweight bonds tied to pharmaceutical and electric companies. “They tend to be less subject to changes in the economic conditions,” he said.
Zane Brown, partner and fixed income strategist for Lord, Abbett & Co., Jersey City, N.J., said his firm's core fixed income strategy — which returned 6.09% in the second half of 2007 — is overweight bonds for chemicals, metals and mining companies.
Companies from those industries stand to benefit from global infrastructure projects going on across the globe that have nothing to do with the U.S. economy, he said.
Mr. Phillips said BlackRock has made substantial bets on the commercial mortgage-backed market. He declined to say how big that bet was, but said “it's the largest overweight we've ever had in CMBS.”
“We think the underlying fundamentals (of the commercial mortgage market) are drastically different from the (subprime) residential market,” Mr. Phillips said.
He explained that CMBS are backed by longer dated mortgages and do not have adjustable rates like subprime residential mortgages. Yet, prices on commercial mortgage-backed securities have been hammered worse than the residential sector because hedge funds and proprietary trading desks were forced to sell these highly liquid securities during the credit crunch in order to meet margin calls.
Municipal bonds are also showing up more heavily for the first time in some portfolios. The 10-year AAA general obligation municipal bond is yielding 4.02% and the 10-year Treasury is yielding 3.41% as of the morning of March 14.
“We're in a situation where municipal yields are higher than Treasury yields,” said Tammie Arnold, managing director and co-head of product management for Pacific Investment Management Co., Newport Beach, Calif., which has $340 billion under management in core bond portfolios Those yields are up due to forced selling by hedge funds and concern over the bond insurance industry, Ms. Arnold said.With only $60 million in assets, Integrity Fixed Income Management LLC Chief Investment Officer and founder Earl Denney knows his Orlando, Fla.-based firm is a long way away from the behemoths like PIMCO and BlackRock.
Chance for new fixed income managers to shine
But the current market environment offers a chance for new fixed-income managers to shine and former stars to fade. In the second half of 2007, Integrity's high-grade government/corporate strategy returned 7.55% and was the second highest performing portfolio in eVestment Alliance's core fixed-income manager universe.
“It's a business opportunity for us. When you have a large dispersion of returns, a lot of managers are going to underperform pretty dramatically,” Mr. Denney said. “As a new manager, when most managers underperform their benchmarks that can lead to a lot of turnover, which can lead to a lot of opportunities for new accounts.” Integrity won a $10 million core fixed income mandate from the $200 million Southern Baptist Foundation, Nashville, Tenn., in the second quarter of 2007.
Other managers didn't fare as well. Hyperion Brookfield Asset Management Inc., New York, was one of the bottom five performing core fixed income strategies in the eVestment database, with a 1.39% return for the last six months of 2007.
Joe Syage, a managing director and portfolio manager for Hyperion said their performance was a matter of timing, and that returns would swing up again.
The strategy was more heavily into mortgages than many core fixed income strategies, but they were high-quality assets. Those assets, which include commercial mortgage-backed securities and non-agency residential mortgages, have not seen a deterioration in quality, he said.
“We feel very confident that what we own is going to be fine,” Mr. Syage said. “We're confident these will still pay out and time will bail us out.”
Contact Jay Cooper at jcooper@pionline.com
