Managers Tiptoeing Toward the Exits in Corporates

For intermediate-term bond funds, a healthy allocation to credit has been a boon to recent performance. The Bloomberg Barclays Investment-Grade Corporate Index gained 6.3% annualized, in 2016 and 2017, while the Bloomberg Barclays High-Yield Index generated an explosive 12.2% annualized during the same period. Compared with the far more modest 3.1% of the broad Bloomberg Barclays U.S. Aggregate Bond Index, exposure to credit was a discernable performance advantage.

Today, managers are worrying that the credit party is about to end. The markets are starting to become more volatile as some head for the exits. In January 2018, the payoff for taking credit risk reached very low levels so that managers felt there was little reward to taking credit risk. The average option-adjusted spread of the Bloomberg Barclays Corporate Investment Grade Index, a measure of the yield premium earned over a comparable U.S. Treasury, tightened to 85 basis points by January, a level that was last seen in 2007. S&P estimates that the number of highly leveraged corporates has grown to 37%, which is 5 percentage points higher than prior to the financial crisis. Yet default rates remain low. Add to this situation more-positive economic indicators and a Federal Reserve that responds by raising interest rates at its fastest clip in a decade, and there are plausible reasons for portfolio managers to question the endurance of this credit rally.

Two intermediate-term bond funds that have pared back credit exposures relative to the index, given rich valuations, are

PIMCO Total Return

PTTRX and

Carillon Reams Core Plus Bond

SCPZX. Both funds have the flexibility to allocate aggressively to credit when valuations prove attractive, but neither has adopted that posture in recent months. As of late 2017, PIMCO Total Return held around 13% in investment-grade credit and 2% in high-yield credit, while Carillon Reams Core Plus held no high-yield credit and 15% in investment-grade credit. In contrast, the median distinct intermediate-term bond Morningstar Category peer allocated around 30% to corporates, 5 percentage points higher than the corporate allocation of the category’s investment-grade Aggregate Index.

While the two funds’ underweightings to credit are similar, their alternative investment theses noticeably differ. PIMCO Total Return has focused on the mortgage sector, with a roughly 12% allocation to higher-yielding nonagency mortgage-backed securities and 42% of the fund in agency MBS. Carillon Reams Core Plus has built a U.S. Treasury and agency debt position that occupies half the portfolio, presumably building liquidity to take advantage of future volatility in the credit markets.

In the case of PIMCO Total Return, the fund’s performance has delivered despite its contrarian credit positioning. It outperformed two thirds of its distinct peers in 2016 and 2017 and kept pace with those carrying a more-structural credit bias, such as