Variety of fixed-incomes strategies met challenges of 2nd quarter

Strategies in Morningstar's ultrashort bond category, including some liquidity and cash management portfolios, took half of the spots on the list of top-performing fixed-income strategies for the year ended June 30, according to Morningstar Inc.'s separate account/collective investment trust database, as inflation continued to be a concern and the Federal Reserve raised interest rates at two consecutive meetings during the quarter.

"U.S. Treasury rates that had maturities of two years, five years, 10 years and 30 years each rose about 70 basis points during the second quarter. It was a highly unusual parallel increase in the U.S. Treasury yield curve over such a short time period," said Peter Marchese, a senior fixed-income manager research analyst at Morningstar in Chicago.

In the second quarter, the Federal Open Market Committee raised the target range for the federal funds rate by 50 basis points in May before a 75-basis-point increase in June to a range of 1.5% to 1.75%.

The interest rate increases were not unique to the United States, Mr. Marchese said. Central banks in about 70 countries have raised short-term interest rates by at least 50 basis points so far in 2022. "This is part of a global movement by the central banks to reduce the inflation that is hitting other parts of the world, as well as the U.S," he said.

Bond markets are starting to believe the Federal Reserve is committed to bringing inflation down to its long-term target of 2%, he said. "Inflation expectations in the bond market have actually been reduced meaningfully, especially once you get to 10-year inflation expectations, which are already back down near 2%. So it's a positive sign that the bond market believes that the Fed will continue to raise short-term interest rates and will be successful in lowering inflation," Mr. Marchese said.

The first quarter of 2022 saw negative returns across all of the major bond indexes and those negative returns continued into the second quarter. "That rarely happens," he said. "That also includes the returns on municipal bonds. There really wasn't any place to hide from rising interest rates with any type of fixed-income strategy."

The Bloomberg Short-Duration 1-3 Year Treasury index returned -3.5% for the year ended June 30; the Bloomberg U.S. TIPS index returned -5.1%; the Bloomberg U.S. Aggregate Bond index, -10.3%; and the Bloomberg U.S. Long Treasury index returned -18.5% for the year.

"Despite the lowering of inflation expectations, even U.S. TIPS have generated negative returns. So even inflation protection was not a safe haven for bond investors to avoid negative returns," Mr. Marchese said.

In addition to inflation and rising interest rates, concerns about recession grew during the second quarter and had an impact on corporate bond markets, he said. "A fear of an upcoming recession increases the fear that some companies won't be able to pay their bonds back and it didn't make a difference whether they were high-quality, investment-grade bonds or whether they were high yield," Mr. Marchese said.

The Bloomberg U.S. Corporate High-Yield index had a one-year return of -12.8% and the Bloomberg U.S. Corporate Bond index returned -14.2% as of June 30.

16th Amendment Advisors LLC's Vicksburg strategy rose to first place on Morningstar's one-year list with a gross 26.65% return, up from second place at the end of the previous quarter. The strategy remained on top of the overall domestic five-year list, with a 33.78% gross return for the five years ended June 30. All multiyear returns are annualized.

The Vicksburg portfolio, which is in Morningstar's U.S. municipal national long-term bond category, holds taxable and tax-exempt investment-grade municipal bonds, corporate bonds and their hedges as a total return institutional fixed-income strategy, according to Vicksburg's Morningstar fact sheet. Officials declined to comment.

A multisector bond strategy from Provident Capital Management Inc. was in second place for the year with a gross 4.67% return. The PCM Absolute Bond strategy holds "a proprietary allocation of various domestic and international ETF debt instruments of varying durations and credit quality," with an emphasis on low volatility, consistent income and the preservation of capital through challenging markets, according to the firm's website.

T. Rowe Price Group Inc.'s dynamic global bond strategy was third for the year on the list of top performers, with a 4.64% gross return. The portfolio, which is in Morningstar's non-traditional bond category, holds U.S. and international debt securities.

"I think one of the real edges we have is taking a very global perspective," said Arif Husain, the London-based lead portfolio manager for the dynamic global bond strategy and a co-portfolio manager on other bond strategies. Mr. Husain is also chief investment officer, fixed income; head of international fixed income; and a vice president of T. Rowe Price Group Inc. and T. Rowe Price International Ltd.

Mr. Husain said that in addition to hedging currency risk, the strategy's global outlook benefits from the dispersion of central bank views on monetary policy in and outside the U.S.

"We had a view that the Fed was going to hike but we've managed to find other countries in the world where they've either raised rates a lot earlier, and got them to good levels, or they are on hold. Or there are some countries, very few, that we've invested in that are actually cutting and their bond markets are performing pretty well," Mr. Husain said.

The strategy was also well positioned early for the rise of inflation, he said, with about 30% of the portfolio allocated to TIPS and other inflation-protected global securities. Mr. Husain expects market volatility and the rising interest-rate environment to have a continued impact on fixed-income yields, so investors will need to look beyond a traditional approach to fixed-income security selection and sector construction. Interest-rate and duration management are essential considerations in fixed-income portfolio construction in the current environment, he said.

"There are very few strategies that take meaningful and bold duration decisions, interest-rate decisions. We're a strategy that is very, very happy to take strong views on global interest rates, on U.S. interest rates, and have done so for a long period of time. That's been a very, very successful driver of our return," Mr. Husain said.

Laffer Tengler Investments Inc.'s dynamic U.S. inflation strategy moved to fourth place on the list of one-year returns with a gross 3.63% as of June 30, down from the top spot at the end of the first quarter. The strategy is in Morningstar's U.S. inflation-protected bond category.

Federated Hermes Inc.'s trade finance ultrashort bond strategy rounded out the top five with a 0.95% gross return for the year ended June 30.

The median return for limited-duration strategies in Morningstar's universe was -1.39% for the quarter and -4.68% for the year; the median return for TIPS strategies was -6.22% for the quarter and the median return for the one-year period was -4.98%; the median return for domestic high-yield strategies was -9.15% for the quarter and -11.18% for the year; the median return for long-duration bond strategies was -12.41% for the quarter and -20.44% for the year; and the median return for Morningstar's entire domestic fixed-income universe was -3.07% for the quarter and -6.94% for the year ended June 30.

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.

Inflation-protected bond strategies dominated both the one- and five-year lists in Morningstar's domestic collective investment trust universe, holding seven spots for the year and nine of the top 10 for the five years ended June 30.

Northern Trust Asset Management's Short-Term Investment Fund CIT topped the list with a one-year net return of 0.34%. State Street Global Advisors' Cash Series Short-Term Investment Non-Lending Index C was second for the year with a net return of 0.27%. Invesco Ltd.'s Short-Duration Inflation-Protected Treasury C portfolio was third with a 0.24% net return. T. Rowe Price's U.S. Limited-Duration Inflation-Focused Bond Treasury Z was in fourth place with a 0.16% net return for the year ended June 30 and was third on the five-year list with a net return of 3.33%. Fidelity Institutional Asset Management's Target Date Treasury Bill Index Commingled Pool completed the year's top five with a net 0.1% return.

Wellington Management Company LLP's CIF II Treasury Inflation-Protected Securities fund was in first place for the five-year period with a net return of 3.35%, followed closely by AllianceBernstein LP's U.S. Inflation-Linked Securities Collective Trust B with a net 3.34%.

State Street's U.S. Inflation-Protected Bond Index Securities Lending Class II fund held fourth place with a 3.323% five-year return, slightly ahead of BlackRock Inc.'s U.S. Treasury Inflation-Protected Securities F in fifth place with a 3.32% return for the five years ended June 30.

All data for Pensions & Investments' top-performing managers report are provided from Morningstar's global separate account/collective investment trust database. Data for the separate account rankings on which this story is based were pulled Aug. 10 and data for CIT rankings were pulled Aug. 16.