Intermediate Core-Plus Bond Funds Get Adventurous
These three funds are being bold with their securitized exposure.
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.
Alfonzo Bruno does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.