Most of the funds we grade were overweight credit, including high yield, throughout the year. The managers expected deleveraging would continue without a significant rise in the default rate (bar a couple of well-known problems in high yield credits).
While they expected this to lead to low, slow growth, they felt that real yields on Treasuries were unattractive, and therefore most portfolios were underweight interest rate duration but overweight spread duration in the first half.
However, managers avoided European bank issues and, in Pioneer’s case, US money centre banks as well, as they were nervous about contagion from the eurozone crisis, and therefore performed better against their benchmarks than many eurozone fixed income funds.
Nevertheless, most non-specialist funds we grade underperformed their benchmarks last year and the overweight to credit was an important factor in that.
Duration key
The other driver of returns was duration positioning, either because portfolios were actively underweight or because they were not sufficiently overweight to counteract widening credit spreads.
Pimco’s Total Return Fund is the best-known example of underweight duration being exacerbated by curve-steepening trades. Bill Gross limited the damage by reversing the position and going long in the third quarter, but the trade continued to detract through September.
Fidelity’s US Dollar Bond Fund was an exception to the general trend as it outperformed its benchmark in 2011. It benefited relative to peers as its benchmark is longer duration than most.
However, Rick Patel cut the portfolios overweight to corporate credit after the Japanese tsunami and went underweight financials and overweight duration. He then correctly reversed these positions in Q4 and ended the year top decile within the peer group.
MBS picture mixed
The mortgage-backed market had a relatively uneventful year, except that changes to the pre-payment assumptions in the BarCap mortgage-backed indices led to index duration moving sharply, which made matching the index more difficult.
GNMA securities continued to outperform FNMA and FHLMC, partly because of lower refinancings on higher coupon securities and partly because they receive a more favourable regulatory treatment for risk weightings and liquidity coverage ratios.
Franklin Templeton felt that there is some risk that these regulatory advantages may be removed in the coming year. BlackRock anticipates that HARP 2.0 could increase pre-payments on non-GNMA mid-coupon issues and is revising its model to account for this.
Both Franklin Templeton and BlackRock have been switching down the coupon stack as they believe refinancings on 3% and 3.5% coupons are not likely for some time.
Outlook
All the managers we spoke to expect low and slow growth in 2012 and the Fed to remain on hold for some years. They feel the housing market may be bottoming, although there is still considerable overhang and potentially more forced selling and repossessions to come, particularly in higher-priced properties.
Jobs growth would help and employment numbers seem to be improving somewhat. Immediate risks to GDP are still expected to be external (oil prices, China’s hard landing, eurozone crisis). Although everyone expected the US fiscal situation to remain stable during this election year, a number of managers expressed concern about 2013.
They hope for a grand bargain but fear this will not happen and that fiscal drag from tax cuts expiring and further concerns around the level of Federal debt will become issues next year.
