Head of the Class | Published in May 2009

Over the Falls?

It could be both the best and worst of times for fixed income.

By John Keefe | May 2009
Page 1 of 4 View Full Article
Illustration By John Hendrix

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us." So, in the opening passage of A Tale of Two Cities, Charles Dickens described the turbulent time of the late 1700s, and likened it to his world in 1859.

The credit markets of 2009 are similarly a puzzle and paradox. Core-plus strategies have fallen far short of lower-octane core portfolios. Yields in some bond market sectors are at record highs, others at their lowest in centuries. One market is calling for deflation, while others fear soaring inflation from large government deficits. Yet, for the predominant bond holding of pension plans—investment grade corporates—managers see a spring of hope, with everything before them.

During the tumult in the stock markets of 2008 and 2009, bonds worked as they should—or at least many did—and ­cushioned the losses in equities. U.S. Treasury bonds, both long and short durations, made strong gains for the year (see chart, next page, illustrating 10 years of annual returns for several bond market sectors).

"We've seen a flight to quality, one of the strongest in history," notes Mercer Investment Consultant Terry Dennison, stationed in Los Angeles. "Long Treasurys were up 30% last year, and yields have dropped to very low levels," he adds.

"In late 2007, 2008, and going into 2009, you wanted to err on the side of greater liquidity, rather than trying to add return through credit risk," says Gary Madich, Head of JPMorgan Asset Management's Columbus, Ohio, Fixed Income Operation, which runs the firm's core strategy.  

Disappointment arose in the credit sectors: The Barclays Capital (née Lehman Brothers) Credit Bond Index was off 3% for the year, while the firm's index of high-yield bank loans, not shown on page 59, was down 29%—nearly as much as ­equities. "Exposure to credit and other spread sectors in the past 18 months have wiped out [more than] 20 years of excess returns in bonds," observes Marko Komarynsky, Head of Fixed-Income Manager Research for Watson Wyatt Worldwide.

While fixed-income managers braved the markets, institutions staged a retreat, slowing their searches and hiring. In the worlds of both core and core-plus, ­investors both added and withdrew about $25 billion to each during the year, most of which moved in the first half, according to eVestment Alliance.

Long-duration strategies that underpin most implementations of liability-­driven investing (LDI) grew considerably, however, adding about $40 billion in net new capital to the category's $260 billion in assets at the start of the year. Firms scoring big wins in long duration include Wellington, BlackRock, PIMCO, Goldman Sachs, and NISA Investment Advisors. "Sponsors are getting closer to pulling the trigger on LDI," says Madich. "It's becoming a real-live discussion, certainly in the corporate world and, with the funding concerns of public plans, I think there will be an opportunity there as well."