As rates rise and Treasuries look less attractive, the appeal of go-anywhere bond funds is only likely to grow. Even so, they still need to prove themselves in this new environment.
Made up of just 27 managers with a three-year track record, the Flexible Income sector is smaller and less heralded than the Multi-Sector Income category, but it lives up to its name and boasts superior average returns over one, three and five years.
In fact, over those time periods as well as over the past decade, it is the top performing US Dollar Bond category.
Managers in this category have been boosted by their ability to buy more than just debt, with common and preferred stocks also admissible in their funds. The latter here have really made their mark on the sector, proving particularly popular with portfolio managers. Some are tipping them to be a powerful tool to help investors navigate the changing credit environment in 2018.
‘Preferred securities are one of the best performing fixed income classes out there,’ said Citywire AAA-rated Eric Chadwick, who manages the Destra Flaherty & Crumrine Preferred & Income fund alongside Bradford Stone.
The fund boasts the second best risk-adjusted returns in the category over three years and is in the top 10 for total returns over one, three and five years.
Chadwick said preferred stocks have been in a sweet spot in the low-yield post-crisis era, benefiting as investors reached for income. Their popularity has been helped by banks paying historically high dividends, as a result of new capital rules. ‘It was a perfect storm of a global search for yield,’ Chadwick said.
‘We've seen tremendous interest in preferred securities,’ he said. ‘Investors have been starved for income and have really been putting a lot of money to work. Typically, when we look at our performance versus competing strategies with lower allocations to this sector, our allocation tends to pay off.’
Baker believes the sub-asset class will continue to prove its worth in a rising rate environment, arguing that the secret to success in 2018 will be picking the right preferreds – specifically adjustable-rate securities, also known as fixed-to-floating or floating rate. This floating rate structure provides protection against interest rate rises and has an effective duration of four and half years, he said.
Chadwick, who holds between 65% and 75% of the fund in preferreds, added: ‘You’re getting the benefit of yield but you’re taking substantially less duration risk.’
Over three years, he is top of the category for total returns, beating both First Trust’s Scott Fleming and Robert Wolf and Nuveen’s Baker and Langenfeld into second and third respectively. His 29.5% return is well ahead of Fleming and Wolf’s 22.9%, but these numbers hide a horrible 2017. His one-year numbers to the end of January 2018 place him rock bottom of the peer group, with a -3.2% return against the category average’s 6%.
His fund is broader than those that focus on preferreds, including assets such as high yield bonds, bank debt, common stocks and cash.
As a high-conviction and contrarian manager, Berkowitz boasts one of the most pronounced active shares around, but such an approach can backfire when calls go against him. The Fairholme Focused Income fund fell by 6.2% in one day in February last year when its 18.7% combined position in Fannie Mae and Freddie Mac was hit by a court case that ruled the firms must pay all of their profits to the government as dividends, rather than to investors.
Berkowitz may be contrarian but he is not immune to the will of the crowd. At the start of this year he reduced management fees for this fund and his larger Fairholme fund from 100 basis points to 80 in a bid to stem outflows.