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What Opportunities Remain in Fixed Income?

Not many, but commercial mortgage-backed securities may have more room to run.

The article was published in the January 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

Like financial markets broadly, fixed-income assets went on a wild ride in 2020. Bonds entered the year coming off a hot 2019, with most assets more richly valued than at any other time since the global financial crisis. Of course, that was turned around in early 2020, with most asset types experiencing swift and painful drawdowns. From Feb. 20 through March 23 last year, high-yield corporate bonds (as measured by the ICE Bank of America U.S. High Yield Index) lost almost 22%, while investment-grade corporate bonds (as measured by the Bloomberg Barclays U.S. Corporate Bond Index) lost more than 12%.

But since then, markets have rebounded in impressive fashion. From March 24, 2020, through February 2021, high-yield corporate bonds gained almost 35%, while investment-grade corporate bonds gained over 18%. Indeed, spreads on both high-yield and investment-grade corporate bonds are below their three-year average and in both cases are approaching the tight levels seen in January 2020, immediately preceding the crisis. Many other fixed-income sectors have experienced similar performance patterns.

Despite the market's impressive rebound, 2021 has kicked off with increased fiscal stimulus and a new worry: rising inflation. Since the start of the year, the U.S. 10-year Treasury yield had risen from 0.93% to 1.64% as of March 12, a gain of 76%. The 10-year yield is a key measure of both growth and inflation expectations; it may rise in cases where the market expects a strong economic recovery and/or in cases where it expects rising inflation. Both can be true simultaneously, though it is clear that inflation fears are a component this time. The 10-year break-even inflation rate--the market's proxy for inflation expectations--rose from 1.99% at the end of 2020 to 2.26% as of mid-March 2021.

So, where have portfolio managers turned when seeking new opportunities? One area is commercial mortgage-backed securities. This sector is effectively a bet on commercial real estate, which has been severely hit by the pandemic and subsequent lockdowns. As a result, the CMBS area has been slower to recover than most other fixed-income sectors and still trades wide relative to its historical average. But in the current world of generally unattractive investment opportunities, this leaves CMBS as one of the few areas of untapped potential. Indeed, many asset managers have noted that the CMBS sector offers attractive yields relative to equivalent-rated corporate bonds, even though many risks remain as the pandemic drags on.

Which managers have recently increased exposure to this opportunity?

Carillon Reams Core Plus Bond SCPZX, which has a Morningstar Analyst Rating of Bronze, is run by an experienced team whose nimble approach has delivered over the long haul. Five comanagers, four of whom have more than 15 years' tenure at Reams and 25 years or more of industry experience, support lead manager Mark Egan on this strategy. Reams Asset Management worries about permanent loss of capital rather than volatility, and its hallmark is waiting for market sell-offs to appear divorced from fundamentals before buying. As CMBS sold off sharply in the pandemic-driven sell-off in early 2020, the team decided to pounce on bargain prices. Its CMBS allocation rose to 12.0% at the end of December, up from just 1.1% at the beginning of the year. Contrarian plays like this have rewarded patient investors over the long haul. Through February 2021, the strategy landed in the top decile of its intermediate core-plus bond Morningstar Category for the trailing 15 years.

Silver-rated PGIM Total Return Bond PDBZX courts volatility but boasts a methodical approach, a strong risk framework, and impressive resources. The strategy is run by an experienced team with more than 20 years of experience and is backed by a group with big research manpower by virtue of a cadre of portfolio managers and roughly 100 analysts, which includes a large staff dedicated to securitized debt, including eight managers and 10-plus analysts. This team focuses on finding issues that have good fundamentals but generate a healthy amount of income. In 2020, the team focused on high-quality AAA rated CMBS, outside of the hotel sector, which boast 30% credit enhancements, greatly limiting the downside. The team raised its CMBS allocation to 11.9% as of December 2020, up from 8.5% at the start of the year. From March 2011 through February 2021, the strategy's 4.8% annualized return landed it in the top quintile of its intermediate core-plus bond category peer group.

Still, many managers have adopted a more cautious view toward CMBS because commercial real estate has been hit so hard by the pandemic. Here's one manager we like that has mostly shied away from the space.

Gold-rated Metropolitan West Total Return Bond MWTIX is backed by an impressive group that executes a strong process that balances flexibility and discipline well. Tad Rivelle, Laird Landmann, and Steve Kane have been running this fund since its 1997 inception. The trio managed portfolios together at Hotchkis & Wiley in the early 1990s before leaving to found MetWest in 1996. Before that, they worked together at Pimco. The specialist ranks supporting these generalist managers are also impressive and experienced. For example, rates specialist Bret Barker came on board in 1997, while mortgage specialists Mitch Flack and Bryan Whalen have been with MetWest since 2001 and 2004, respectively. (Whalen joined the generalist team in 2013 and became a named manager on this strategy at the same time.)

The team has the resources to dip into CMBS, but it kept its exposure to the space around 1% for most of 2020. Nearly all of the strategy's risk-taking in 2020 came through investment-grade debt, while junk and nonrated assets remained under 7.0% (the intermediate core-plus bond category peer median was 10.4%). Structured credit stakes in asset-backed securities, nonagency mortgages, and collateralized loan obligations have all held steady in favor of the opportunities described above, although the managers did target CMBS as a fruitful area going forward.

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