Andy Chorlton, head of U.S. multi-sector fixed income at Schroders doesn't have a crystal ball.
In managing the firm's $111.8 million Schroder Broad Tax-Aware Value Bond Fund, however, he evaluates market indicators to see where interest rates could go as he seeks to maximize after-tax returns for the value-driven, quality-biased and total return focused portfolio.
The fund primarily invests in tax-exempt bonds, but will invest in taxable bonds when they are deemed undervalued. The fund held nearly 87% in municipal bonds, 11.1% in corporate bonds, 1.3% in asset-backed securities, 0.8% in cash and equivalents, and no U.S. Treasuries as of March 31, according to the firm's website.
Chorlton is part of a seven-member portfolio management team that manages the tax aware portfolio using two main strategies: sector and security decision-making, and interest rate exposure.
Within the sector and security strategy, he builds liquidity or uses cash to take advantage of imbalances in the relationships among sectors and individual bonds in the market to capture value, regardless of the content of its Barclays Municipal Bond Index benchmark.
Within the interest rate strategy, he assesses the view of potential rates by starting with the three-year forward rate and adjusts this forecast to cushion the portfolio.
"We try to take what we currently have in the market - and the expectations that are priced in - and build a cushion around it," while building interest rate exposure and total return, he said in an interview.
Luckily, using a three year horizon agrees with the municipal tax-aware shareholders, especially institutions, who typically have a long-term investing outlook.
He said the approach allows him to take advantage of the steepness of the yield curve and clients' time horizon, while building a portfolio that is more "resilient" against market moves.
"We prefer to have a more objective way of building interest rate exposure," and it creates a more differentiated fund, he said.
The fund's duration was 4.89 years, as of March 31.
"If yields plummet lower we would slowly reduce duration," he said. "If yields rise we would extend the duration."
That was the case last year when Chorlton said he slowly reduced duration and took advantage of the municipal trade opportunities, while also putting some money into the high quality energy sector.
That fit in with the fund's quest to add value from other sectors, he said, as the energy sector has offered sufficient value and compensation from large cap, high-quality, strong investment-grade names that weathered the oil crisis.
He recently bought some of those lower-risk credits at high-risk prices, such as Noble Energy Inc. bonds with a 3.90% coupon due in 2024, he said, as they were "mispriced because of the sentiment of the sector."
His fund is able to own up to 50% in non-municipal securities, while retaining a tax-free distribution, he said. "What we try to do is take our main skill - the ability to move between sectors - and marry it with a three-year view of where interest rates will be."
A flexible duration allows clients to earn potential yield opportunities, while waiting for "the inevitable interest rate rise," he added. "If your client is concerned about rate rises, this fund can address that concern and not give up yields."
Chorlton has noticed a subtle change in investors' approach in the last few months as the expected rate increase "feels a bit closer," he said. "The current level of yields has changed people's risk reward tolerance. We are seeing people question the risk-reward in their fixed income portfolio."
They have digested the low yields, yet still prefer municipals because of their tax advantages. "People still want maximum after tax returns," he said.
So, instead of replacing interest rate risk with credit risk to compensate and deliver higher yields, Chorlton maintains a high-quality bias — especially since credit spreads have compressed in recent years.
The fund recently had a credit quality allocation of 51.1% in double-A-rated paper, 28.6% in A-rated paper, 14.8% in triple-A-rated paper, and 5.5% in triple-B-rated paper, as of March 31.
"We shouldn't take equity type risk in a muni portfolio," he said.
The portfolio holds school bonds, such as Moreno Valley, Cal., Unified School District zero coupon bonds of Aug. 1, 2025, and the Perris, Calif., Union High School 5% coupon bonds due on Sept. 1, 2023.
The quality-driven, total return-focused strategy is helping the three-year-old fund thrive, though fund performance "has been a bit more neutral" and flows have moderated this year, he said.
The fund's investors' shares have a one-year return of 9.91% versus its benchmark's 6.62%, and a three-year return of 6.43%, compared to 4.05% for its benchmark. It has returned 7.12% since its Oct. 3, 2011 inception, versus its benchmarks' 4.61% as of March 31, according to the firm's website.
"There are concerns the economy isn't as robust as every one would hope, but we think the Fed needs to move and has a clear incentive to get away from zero," he said.
To prepare for the rate increase, Chorlton said he is building liquidity across the fund, which is five-star rated by Morningstar Inc., to be better positioned if there is a repeat of the selling spree that marked 2013.
"We are a bit concerned that what we saw in 2013 in the municipal market could be a dry run and practice run for what happens in the municipal market when the Fed raises rates," he said.
The decision by investors two years ago to withdraw $70 billion in a mass exodus from the municipal market triggered historic weakness.
"There was a big gap until the cross-over buyers got involved," Chorlton said.
Though there are municipal buyers in the market now, Chorlton said he is concerned that there will be a lack of news buyers if recent rate bias again prompts selling.
Chorlton's target is to have a 20% liquidity buffer leading up to a potential rate hike to take advantage of investors "suffering asset allocation changes," he said.
"We want cash in Treasuries and to build liquidity so we can take advantage of other peoples' pain," which could be triggered by the Fed raising rates higher than expected, a potential risk-off trade in the European market, or other unexpected events, he said.
The team manages $16 billion of U.S. multi-sector fixed income assets, of which more than $2.6 billion is in tax-aware value strategies.
"Once people understand how we are looking at the world, they become believers," Chorlton said of Schroders' investment strategies. "We have seen a lot of conversion from benchmark mandates to a more opportunistic approach."
