One Bond Manager's Trip Through the Latest Storm
PGIM's bond funds have performed much as we would have expected.
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A version of this article was published as a Fund Analyst Note on April 13, 2020.
The six PGIM taxable-bond strategies that are under Morningstar analyst coverage had a bit of a rough ride when the coronavirus crisis first began thrashing global bond markets. But while the pain was worse than that felt by comparable peers' in some cases, there was little that ranked as surprising or catastrophic given the funds' underlying strategies . We did not elect to change any of the Morningstar Analyst Ratings for PGIM Short Duration High Yield Income (HYSZX), PGIM Global Total Return (PZTRX), PGIM Short-Term Corporate Bond (PIFZX), PGIM Absolute Return (PADZX), PGIM High Yield (PHYZX), or PGIM Total Return Bond (PDBZX).
The worst of the bond market's earliest coronavirus-triggered reactions generally occurred between late February and late March 2020, and while the future is still opaque, a great deal of the trouble for higher-rated debt was driven by a drop in market liquidity, much of which returned when the Federal Reserve began announcing multiple programs to put the system back on firmer footing.
So, while each of the PGIM bond funds that Morningstar covers endured downdrafts, they have all bounced back to one degree or another. The reasons for their pain weren't all the same given differences in strategy, but themes on which the firm has focused affected more than one portfolio. One has been a distaste for Treasuries and agency mortgages, which PGIM has almost universally found too expensive for its tastes. Historically a fan of corporate bonds, meanwhile, the firm had previously mounted a prolonged tactical shift from an emphasis on corporate debt to securitized exposure. Like many competitors, PGIM began viewing corporate-bond valuations as too rich on a broad basis a few years ago and looked for underappreciated sectors offering better rewards in exchange for their risks. Collateralized loan obligations filled that bill for many firms, though PGIM has been among the most enthusiastic. PGIM Total Return Bond, for example, had 16.9% exposure to the sector at the end of February 2020, with a focus on its highest-rated tranches. Its managers favored other securitized sectors as well, and as of the same date, that strategy held 13.7% in commercial mortgage-backed securities and 5.9% in nonagency mortgages. So, while the portfolio bounced and rallied strongly in the weeks thereafter, it fell roughly 10% during the first three weeks of March.
CLOs distinguished themselves during the 2008 global financial crisis, in that no top-quality tranche of a CLO defaulted during that period, and the industry responded to worry over the sector's future by building newer versions with even better protection for their higher-quality slices. Nonetheless, the underlying loan market has exploded in size since the 2008 crisis, and its own character has shifted with its popularity, opening it to a broader universe of riskier borrowers. Meanwhile, CLOs have been voracious buyers in that universe, while ownership of new CLOs themselves has become relatively concentrated (Japanese financial institutions are reputed to have swallowed up massive issuance). Those factors alone meant there was some concern over the sector prior to the COVID-19 crisis, and its day-to-day secondary-market trading had long been relatively light. Not surprisingly then, even the highest-rated CLO tranches were marked down sharply when COVID-19 market shocks hit as liquidity briefly vanished from multiple sectors. Pricing during that kind of chaos can be difficult to pin down, but some high-quality tranches reportedly traded off by 10% or more when conditions were at their worst. As noted, though, most of the sector's higher-quality tranches have been on the mend, as have those in the CMBS universe, which helped several PGIM funds in late March and April.
The overall group also manages PGIM Short Duration High Yield Income and PGIM High Yield, both of which have felt pain as well. But while it's likely little comfort to those aching from seeing big drawdowns, both strategies acted much as one would have expected versus their peers and benchmarks during the sell-off, given their approaches. The short-duration portfolio placed right around the middle of a (unique) subset of funds focused on shorter-duration high-yield funds, while the firm's flagship high-yield offering placed right around the middle of the overall high-yield bond Morningstar Category.
Neither of those strategies carried an extreme profile going into this crisis, but both were positioned on the aggressive side relative to their benchmarks. As such, their managers' decisions to begin taking risk off the table in February by purchasing protection via high-yield credit default index swaps, and accelerating that effort in March, were a major factor in keeping them from worse fates. Those exposures hit up into the midteens and as high as 20%, but the team also actively trimmed these hedges as the market went down. Doing so helped ensure that the strategies would be ready to take advantage of a rebound. (Credit default index swaps are essentially high-yield index baskets.)
More broadly, all of PGIM's taxable-bond strategies were likely protected from worse trouble by risk-management protocols across its investment menu. Those strategies operate with a well-defined framework that employs thresholds beyond which portfolios aren't meant to stray. Once managers press up against them, they're required to give up risk in one area if they want to add any in another. No such system is perfect, but PGIM's has helped keep the group focused on balancing its bets even when it has been a more aggressive player in certain areas.
A key element of that system also involves making sure that the strategies can withstand significant investor outflows. PGIM Absolute Return and PGIM Short Duration High Yield Income saw notable outflows in March. And though a couple of funds modestly tapped credit lines to help manage redemptions without sending portfolio allocations out of whack, the firm employs strong guidelines to avoid serious trouble if investors elect to pull significant sums from its funds very quickly. Those include stress tests that assume widening bid-ask spreads and significant redemptions relative to portfolio assets, and rules dictating that funds must still have resilient liquidity even after those events.
Those checks aren't a panacea, but they do tell you something about how PGIM manages risk, even in the context of portfolios that are often a bit more volatile than peers that run with more benchmarklike allocations. Those are features worth looking for among any and all bond managers.
Eric Jacobson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.