The Opportunity for the Unconstrained

A recent article in the major financial press discussed how over the last year there has been a huge increase in inflows into non-index based or unconstrained funds and how the expectation is for money to continue to move out of traditional funds into these unconstrained funds.

We agree with this take.  If you look at the current fixed income landscape, it’s not hard to see why.  Interest rates have steadily come down over the last thirty years, with the Fed keeping short term rates near zero for the last several years.  As money has flowed into the fixed income space and investors search for any yield to be had in this environment, this has driven down not only Treasury yields but also investment grade and high yield bond index yields, as well as municipal bond yields.  In the high yield market, much of the catalyst for the index-base products to appreciate has been the money flows into the asset class.  As Treasury rates were falling this caused the spreads on the risk assets to widen, thus attracting money inflows.  With these inflows, many of the securities held by the index products rise in value despite what the fundamentals tell about the company.  However, when the money inflows stop and the securities in the index products have to perform on their own merits, the market will mark to market where they belong, which may not turn out well.  With many bonds currently trading well above their call prices (negative convexity), these passive products don’t have the mechanism to take profits.  Nor do they have the ability to avoid those companies with weak fundamentals.

Getting back to rates, even though the Fed has stated they won’t be raising short rates for the foreseeable future, longer dated Treasury yields have been rising, with the 10-year Treasury note at 2.85% today.  This is a result of the Fed preparing the way for easing up on its purchases of these long-dated Treasuries, as well as mortgages.  One of the questions we get most is how will we do in the high-yield bond asset class if rates rise?  First off, we don’t believe that rates will climb dramatically going forward, but an upward trend is definitely happening now.  There will be some upward movement merely because the Fed will be less of a buyer and higher rates will likely be needed to attract other buyers.  However, we don’t see the Fed pulling on the rising rate lever like they did in 1994 given the economic backdrop.

Let’s say rates do rise above 3% and flatten out between 3% and 3 ½%.  In this scenario, what would happen to an actively managed portfolio versus a lower cost index-based product?  Historically high yield bonds have performed well when rates rise (see our piece, “High Yield in a Rising Rate Environment”), however some of the longer maturity and lower yielding paper could take a hit.  This would include much of the paper that has been issued during the past couple years of record issuance.  The index-based products must buy these newly issued securities that become part of the index, whereas an active manager like Peritus can be selective.  We largely participate in the secondary market, therefore tend to have a shorter maturity and thus lower duration (interest rate sensitivity) in our portfolio relative to the indexes and the products that track them.   By buying seasoned credits in the secondary market, we often are buying bonds that are already within their call window.   Securities that are expected to be called and refinanced often have very little interest rate sensitivity.

As an active, unconstrained investor, we are able to build our portfolio for the market and economic environment at hand. This centers around doing the economic and fundamental analysis for our prospective investments.  Since the Peritus team has a few decades under our belt in this asset class, we have developed a pretty good process to do this. This process includes building in a margin of safety with each and every security you add to the portfolio; you can’t just add hundreds of securities from every industry and think that’s going to work all the time (as the index-based products and many massive funds that claim to be active do).  This also includes identifying and purchasing assets below what you think it will ultimately be worth.  In managing debt securities, an active manager has discretion of when to buy and when to sell; we are not dictated by a policy and therefore we can avoid many of the pitfalls that index products fall prey to.

Just as the article discusses, we too expect that active and unconstrained fixed income products are much better positioned to withstand the interest rate volatility ahead than the traditional, index-based products.  We believe that actively picking the securities and industries that will do well in the given economic environment will be key as we enter this next phase of the market cycle. Additionally, we can take advantage of any sort of interest rate volatility by buying bonds in the secondary market that have fallen in price, creating a better yield entry point for us and the potential for capital gains.  If you want a product with low fees that merely tracks an index without accounting for rates or anything else, you will get what you pay for.


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