Intermediate Core-Plus Bond Funds Get Adventurous

Times are relatively tough for fixed-income managers. Geopolitical uncertainty, ultralow or negative yields around the world, and the decade-long recovery have resulted in rich valuations in several areas, including corporate credit. As a result, some managers in the intermediate core bond and intermediate core-plus bond Morningstar Categories have relied more heavily on securitized debt over investment-grade and/or high-yield corporates because they believe its various components offer some combination of favorable risk-adjusted returns, good diversification, and ample liquidity. But, like corporate credit, securitized assets are highly correlated to the underlying economy. A change in economic fundamentals can put the sector under pressure, especially for those funds that invest in lower-rated deals. Areas such as credit risk transfers, subprime auto loans, and high-yield collateralized loan obligations are among the most sensitive to changes in the broader economy, all of which are present, in some capacity, within the intermediate core-plus bond category.

The plain-vanilla side of securitized holdings is nothing new. Core bond funds have long invested in agency mortgage-backed securities. The Bloomberg Barclays U.S. Aggregate Bond Index's stake in agency mortgages is just below 28%. Some managers prefer low-risk mortgages for the liquidity benefit and slight yield advantage over U.S. Treasuries. Others, typically in the intermediate core-plus bond group, can be a bit bolder in their securitized exposure.

Here, we highlight how a few managers have emphasized this space in recent years.

PGIM Total Return Bond PDBAX, which has a Morningstar Analyst Rating of Silver, has been active in reducing corporate credit, which had been a longtime overweighting relative to the index, in favor of securitized debt over the past two years. As of June 2019, corporate exposure totaled 32% of assets compared with roughly 50% just two years earlier. In turn, the team increased its securitized stake to 43% from 34% over that same stretch. Most of that exposure sat in asset-backed securities, and PGIM's approach is relatively cautious given that this includes a large stake in AAA and AA rated CLOs (20%). The team argues that CLOs' reasonable valuations and minuscule historic default rates make them a prudent way to obtain attractive risk-adjusted returns. The team has stashed an additional 12% of assets in AAA rated nonagency commercial mortgage-backed securities, and it is wary of owning the lower-rated mezzanine tranches in a late-cycle environment.

Conversely, Bronze-rated AB Income ACGYX prefers more credit risk within its securitized stake, given its managers' optimism surrounding U.S. growth and a healthy consumer. Over the trailing five years through June 2019, the strategy's securitized stake increased by roughly 14 percentage points to 47% relative to a 9-percentage-point decline in corporate credit, which now clocks in at 22%. The fund's 12% allocation to mostly BB and B rated credit-risk-transfer deals is notable. The credit risk transfer is a newer structure in the mortgage market that was first issued in 2013. These securities have yet to be tested during a downturn in the U.S. economy, but AB attests that the risk-adjusted performance of credit risk transfers should fare better in a risk-off environment relative to similarly rated high-yield corporates.

The team behind Gold-rated Metropolitan West Total Return Bond MWTRX has focused on several types of securitized debt for years. Lately, the team reduced its corporate-credit exposure from 33% in September 2018 to 23% as of June 2019 based on valuations. The team pushed its U.S. Treasury exposure higher (28%) in response but still maintains considerable exposure to agency MBS (27%). In addition, the team carries a modest allocation to nonagency mortgages (roughly 7%), which it continues to find compelling given ongoing deleveraging of the underlying loans and low defaults. The team has also kept 5%-6% stakes in both ABS and CMBS. In each case, the team has stuck to higher-quality issues and emphasized the need to stay cautious about the collateral backing them.