Some portfolio managers are taking innovative approaches in their use of benchmarks as they look to more precisely match their clients' goals.
Managers use benchmarks such as the Barclay's five- and 10-year indices to guide their selection of securities by sector and maturity. While many still try to replicate the performance of the benchmark indices they follow, a handful are trying to manage just shy of or exceed the models. Their approach may vary depending on whether they want to provide extra safety by minimizing duration, upgrade credit quality, or boost value with extra income.
Julio C. Bonilla, a portfolio manager at Schroder's Investment Management, strives to exceed the benchmarks he uses as a model for his clients' separately managed accounts.
Bonilla seeks to deliver value to clients based on their investment goals - and he welcomes market aberrations and being "benchmark agnostic" in order to do so.
"For the tax-paying clients we try to get them an after-tax total return that is going to exceed whatever their benchmark might be," Bonilla said.
With a background in municipal bond trading, Bonilla is the loudest voice and biggest proponent for municipal bonds on the eight-member team at Schroder's, a global asset manager that oversees $2.5 billion in separately-managed account assets for traditional tax-paying investors and over $447 billion globally.
He said when using benchmarks, he avoids being under or over-weight in particular sectors if it isn't appropriate for the firm's clients.
"If a sector that was distressed fundamentally didn't make sense, just because it's in the benchmark we're not going to own it," Bonilla added. "We are prudent in that conviction."
The only benchmark characteristic the Schroder team won't compromise is duration, according to Bonilla.
"If a client is risk averse and wants a short portfolio we will stay at a short duration and we generate alpha for that portfolio - looking at all sectors in the fixed- income universe and comparing them to munis," Bonilla said.
He believes the team's approach is unique because "it affords us the opportunity to take advantage of some of the idiosyncratic issues of the market," he said. "We are able to capitalize on the liquidity crunch," in that some of his best performers and yield providers are otherwise fundamentally high-quality bonds that are just "guilty by association" with a similarly troubled credit, sector, or trend.
While Bonilla looks to exceed the returns of his benchmarks, David Litvack, head of tax-exempt fixed income research at U.S. Trust, keeps the duration of his clients' portfolios slightly under their benchmarks.
U.S. Trust manages more than $380 billion in total client assets.
Litvack said active management also allows him to adjust duration and better take advantage of temporary price dislocations than a buy and hold strategy.
"If we see a sector that's underpriced we will buy that if we see spreads tighten because interest rates are so volatile right now," he said.
Meanwhile, Dawn Mangerson and Joe Grabovac - managing directors and senior portfolio managers at McDonnell Investment Management LLC - attempt to meet their benchmarks while staying defensively positioned.
"We have a dual mandate on munis where we want to maximize tax-exempt income, but also have a decent total return," without compromising the risk parameters of the portfolios they supervise ranging in size from $100,000 to over $1 billion, Mangerson said.
As of December 31, 2014, the fixed-income investment specialist managed approximately $12 billion in total assets - primarily investment-grade taxable and tax-exempt strategies -- for institutions, private clients, and mutual fund companies.
They use the Barclays five-year and 10-year benchmark indices as a guide and a risk control mechanism for the separately-managed accounts they run using three intermediate maturity models.
The McDonnell team manages a five-year strategy with a duration of four years that aims to offer principle preservation; a 10-year strategy that focus on the eight to 12-year slope of the curve with a six year duration; and a three to 15-year strategy with a duration of five years that tries to capture value in the most attractive and steepest part of the curve.
"We don't make big duration bets one way or the other," Mangerson said. "If we think rates are going up or down we might lean one way or the other -- 2% long or 2% short or stay neutral to the benchmark," she said.
One slight variation is that the team takes a laddered approach when structuring its portfolios, unlike the Barclays benchmarks they follow, which are bulleted, Mangerson said.
While they take different approaches to using benchmarks, Bonilla and Litvack agree in their use of a cross-over strategy when managing client portfolios to maximize value.
"We don't put 100% of our holdings in munis, but rather look for securities with the best risk adjusted returns," Litvack said.
"Corporate bonds have appeared more attractive on the short end and in the belly of the curve, so we have been buying those for clients with shorter term portfolios," Litvack said of the separately managed accounts that U.S. Trust oversees on behalf of individual high net worth investors.
Relatively attractive municipals in seven years and longer have been among Litvack's recent purchases.
"If we see that interest rates and spreads are shifting and all of a sudden taxable bonds look more attractive longer out we may shift the portfolio longer out," he explained.
U.S. Trust tries to anticipate shifts in the yield curve and position portfolios accordingly, according to Litvack. "Right now, we are anticipating a bear flattening yield curve - when rates rise but faster on the short end and slower on the long end," he explained.
"In that type of environment, we believe a barbell portfolio will outperform a laddered or bulleted portfolio," he said.
As a relative value manager, Bonilla said he also identifies buying investment-grade products within the fixed-income market that will add value over time -- even if they happen to be securities with attractive spreads outside of the municipal universe.
"At certain points [munis] are and at other points they are not as attractive as corporate credits for clients after paying taxes," Bonilla said. This means a "flavor of the day" could catch his eye beyond the tax-exempt market in periods of poor liquidity or lower relative value.
As a cross-over buyer, Bonilla said maintaining liquidity is crucial to him, but can also hinder his participation in municipals.
"To some degree, liquidity can be pretty fickle in the muni space because of the thinness of dealer community and willingness to commit capital," he added.
"Every portfolio manager is struggling with that right now," he explained. "The dealer community doesn't have the capital it once had to help the market."
Overall, many of Bonilla's high-net worth clients in the top tax bracket own a substantial amount of municipal bonds - especially given that triple-A 30-year municipals were yielding 108.3% of the comparable Treasury yield on Tuesday, according to Municipal Market Data.
Bonds on the long-end of the yield curve with 5% coupons and a 10-year par call are among his top picks lately. In addition, he finds value in seven to 10-year maturities where the yield curve is both steep and attractive.
The McDonnell team, meanwhile, favors the long end of the intermediate curve but is wary of its risk characteristics curve given its historic performance and volatility, according to Grabovac.
Mangerson declined to divulge exact trades, but said McDonnell has participated in recent water and sewer offerings because the managers like essential service credits from the high quality sector. A typical trade of interest to Mangerson includes A-rated 5% hospital bonds in the 10-year part of the curve.
In term of coupons, Mangerson said the team prefers premium bonds that are more defensive and offer protection in a rising rate environment.
"In terms of the overall outlook rate wise, we tend to be relatively sanguine because the probability for inflation seems very tame going forward," Grabovac said.
While the team does occasionally blend quality with some income when and if the market allows, Grabovac said credit is the "backbone" of the team's structure.
Most of their management strategies focus on careful security selection as directed by the experience of its nine-member research group.
"Over the last year, we have seen indiscriminate buying and reaching for yield," Mangerson said. While she said her team invested in some higher-yielding credits, such as hospitals and power bonds, they were "very particular" about selecting the best securities within those sectors.
"If we see a rise in rates, we will take an opportunity to sell out of those positions we had to buy at the absolutely low rates last year and book higher yields without giving up credit quality," she said.
