Non-Directional Fixed-Income Investing Strategies

Categories: Drivers of Value

Despite historically low interest rates and the risk of future rate increases, there are ways to make money in the fixed-income market.

Many investors today wonder whether the “ship has sailed” on investing in bonds. Apart from missing the rally, a number of prominent investors have been vocal about their decision to be short U.S. Treasuries over the last few years. These bond bears are quick to point out that the asset class is in a 30-year bull market and that absolute rate levels leave little room to fall.

Since the 10-year Treasury’s record low yield of 1.38% in late July, Treasury yields have spiked sharply. The 10-year Treasury yield rose almost 50bps (1/100 of a percentage point) in less than a month’s time before recovering back to the mid 1.60%’s as of Friday August 24th.

The objective here is not to point out short-term market fluctuations but, rather, to highlight the typical fears that reluctant bond investors face.  It is not practical to time or predict interest rate movements, but it’s helpful for investors to understand that the success of various fixed income strategies isn’t necessarily predicated on continued falling rates.

A handful of actively managed bond funds have shown significant relative outperformance in the face of a multitude of interest rate outcomes. Certain strategies and combinations of assets can perform well without needing rates to fall further.

PIMCO’s “Best Ideas” Fund

PIMCO’s Dynamic Income Fund (NYSE: PDI) is a relatively new name (its IPO was in late May). It invests in a multitude of fixed-income asset classes. As of 24 August 2012,  the fund’s net asset value (NAV) had increased 11.08% since its inception (24 May 2012). The bulk of its outperformance appears to have come from the nonagency mortgage-backed security (MBS) portion of the portfolio, where prices have risen between 5% and 10% over the past few months.

PDI’s holdings in financial corporate debt (Cantor Fitzgerald, Morgan Stanley, Lazard, and Société Générale, among others) have rallied strongly in lockstep with equities. Other exposure in the fund is to high-yield debt and levered loans of such companies as INEOS Finance PLC and First Data Corporation.

Because levered loans typically float to LIBOR, the securities have minimal interest rate risk—just spread and credit risk. PDI is also throwing off a lot of income with a 17.7 cent monthly dividend, which is about 0.65% a month. Remember, although this fund may be less sensitive to interest rates than  more plain-vanilla, U.S. Treasury–heavy bond funds, buyers should understand that is not the same thing as being “risk free.” A substantial amount of credit and spread risk may exist.  Investors also need to understand that unlike an open ended mutual fund which trades at net asset value (NAV), closed end funds can trade at premium and discounts to NAV.

DoubleLine’s Approach

Jeffrey Gundlach’s DoubleLine Total Return Bond Fund (DBLTX) attracted the most money (about $11.5 billion) among mutual funds through June of this year, according to Morningstar. It’s no wonder it has been so popular; as of 15 August, the fund had a total return of 35.95% since its inception (April 2010). The fund has returned an annual equivalent of 13.89%, while its benchmark—the Barclays Capital Aggregate Bond Index—has returned 6.75% during the same period.

The fund has also performed well this year, with a total return of about 6.97% YTD. Since the 10-year Treasury’s record low yield of 1.38% on 24 July, $DBLTX has gone up in price. I would categorize Gundlach’s Total Return Fund as much less “directional” than other funds. While other funds loaded up on longer pass-throughs (high LTV, low loan balance), which trade at premiums to normal MBS pools, Gundlach was busy buying out-of-favor pools backed by higher-balance loans, which trade at a discount.

Although this type of strategy may lag peers if interest rates stay low, I believe his portfolio is set up to make money across a wide range of interest rate scenarios. Nonagency MBS and cash holdings provide a buffer if rates move higher because they are considered “negative duration.” Nonagency bonds are projected to increase in value as the economy improves and rates rise. In my view, the bottom line is that this portfolio is not betting on rates to move in one direction, and Gundlach has demonstrated great skill at combining various assets that outperform as a portfolio.

A New Entrant

A lesser-known fund is the Performance Trust Total Return Bond Fund (PTIAX). This fund has a total return of 10.08% YTD, which puts it in the 97th percentile in its asset class, according to Bloomberg. Since its inception (31 August 2010), PTIAX has returned an annual equivalent of 10.88% versus the 4.75% return of the Barclays Capital Aggregate Bond Index during the same period.

One of the fund’s major benefits is its overall nimbleness. With assets of only about $40 million, the fund can be a lot more selective in its choice of bonds than the DoubleLine or PIMCO funds, which are both substantially larger in asset size. Like PDI and DBLTX, PTIAX has substantial holdings in the nonagency MBS sector.

Because smaller allotments of bonds, or “odd lots,” usually come with a price break, PTIAX is able, in a sense, to buy cheaper bonds than larger competitors can. In addition to nonagency MBS, the other portion of PTIAX’s “barbell” is longer-duration, tax-exempt municipal bonds. In the event of a continued rise in interest rates, the municipal portion of PTIAX should provide a relative volatility “buffer.”

Tax-exempt municipal bonds typically sell off to the tax-equivalent yield; thus, the bonds can be roughly categorized as having? only two-thirds the price volatility of taxable bonds. In plain English, this means that buyers purchase tax-exempt bonds on the basis of the tax-equivalent yield. Therefore, a 100 bp increase in the tax-equivalent yield would increase the tax-free yield by only about 66 bps owing to the tax benefit. Furthermore, municipal bonds still trade at historically wide spreads to U.S. Treasuries, which means that municipal bonds trade at higher yields. If U.S. Treasury yields do rise, spreads could revert to the historical average, which could further mitigate price depreciation. As previously stated, investors would be taking on credit and spread risk by purchasing a fund like PTIAX.

Don’t Write Off Bonds

It is certainly possible to own bond funds and enjoy positive returns without relying on Treasury yields’ falling to new lows. As we have discussed, many of the funds that are most protected from a rise in Treasury yields require investors to take on credit and spread risk instead of interest rate risk alone. Actively managed bond funds, such as PDI, DBLTX, and PTIAX, have shown this to be the case, with outperformance in periods of both falling and rising rates. As with any investment, past performance is no indicator of future performance.

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8 comments on “Non-Directional Fixed-Income Investing Strategies

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  5. I don’t get this:
    In addition to nonagency MBS, the other portion of PTIAX’s “barbell” is longer-duration, tax-exempt municipal bonds. In the event of a continued rise in interest rates, the municipal portion of PTIAX should provide a relative volatility “buffer.”
    In the event that rates rise, wouldn’t the long duration portion of the barbell suffer the greatest losses? Maybe the short end of the barbell has negative duration, and the long end is a buffer if rates continue to fall?

  6. David Schawel, CFA said:

    W- You are right that the muni’s are the longer end of the barbell. I wasn’t trying to imply that those bonds wouldn’t fall in value, rather that they are relatively more insulated to price declines due to their tax exempt nature.

    Sarasota- DBLTX is the institutional share class. The retail share class ticker is DLTNX, and I believe the minimum for that is under $5k.

  7. Wouldn’t it be safer to invest in munies then?
    There may not be the potential for capital appreciation, but it seems like there’s less risk of capital impairment if rates rise.

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