Why Invest in Core Plus Now

[Kyle Airola] Thanks everyone for joining us. I’m your host today. My name’s Kyle Airola. I work on the distribution team here at Segall Bryant and Hamill. Joining me today, our senior portfolio managers on our Core Plus bond strategy, Troy Johnson and Greg Shay. Gentlemen, thanks for joining me. Troy, let’s start off. Yields have moved significantly higher over the past year, and as a result, investors have been flocking to the fixed income markets. So far this year, we’ve seen over $40 billion move into the Core Plus category alone. What do investors need to know about this asset class and these flows in particular?

[Troy Johnson] That’s correct, Kyle. Increased yields have generated increased demand for bonds. The bond market is offering yield again, and investors are just flocking to it. As you can see in this chart, the yield on the Bloomberg US Aggregate bond index, which can serve as a proxy for the yield offer to investors in the market, really moved high over the course of 2022 and continues to sit just shy of 5% today. You’d have to go back about 15 years to 2008 to find the Agg providing this much yield. We do think investors need to be aware that passive strategies are garnering a lot of this attention and the flows. Passive fixed income strategies possess certain structural problems and investors could miss out on certain opportunities.

There are problems for investors worth highlighting in passive strategies. First of all, it’s difficult to replicate the index. Secondarily, the increased duration of the Agg and corporate credit within the Agg, and thirdly, the growth of BBB rated securities within the index. Let me briefly explain each.

It’s very difficult to replicate an index such as the Agg. Replicating a $26 trillion market with 13,000 securities is certainly a challenge. It’s important to note also that this index is built on issuance as well. It’s not based on quality or any credit selection process. Second, we’ve seen a general increase in the duration of the Agg and investment grade corporate bonds within that index. As you see in this chart this increased duration of the years from less than five to well over six can contribute to a less stable or more volatile return profile for fixed income investors as underlying rates move.

Lastly, the aggregate bond index is changing in quality as well, with lower quality BBB rated corporate bonds increasing substantially over the last several years. In this chart, we are illustrating the decline in higher rated corporate bonds with A rating or better as a percent of the index’s corporate weighting. Higher quality A rated or better securities used to represent in excess of 65% of corporate bonds in the index. Today, that number has fallen to about 50%.

In summary, flows from passive fixed income investors are moving into a difficult to replicate index in which the constituents and sizings are not based on credit selection, but rather overall issuance. That same index has seen an increase in duration and lower quality credit, which can contribute to volatility and impact your returns.

[Airola] Thanks, Troy. That’s helpful. So Greg, I’ll turn it over to you. What can investors do to navigate some of these challenges that Troy just pointed out?

[Gregory Shea] Well, thank you, Kyle, and to address these risks of a rules-based index like the Agg and passive strategies, we believe investors should consider an active fixed income strategy that is not constrained by these rules, such as the Agg. Going outside the index casts a much wider net. For example, we see opportunity in the high yield market today, a market with different trends than those previously mentioned. Unlike the Agg or the investment grade corporate index, as you can see in this chart, the duration of the high yield market has actually decreased over the last 15 years. The high yield market’s duration has gone from four and a half years down to three and a half, and while Troy discussed the increased credit risk that the investment grade market is taking, it’s becoming more junky. We’ve seen the opposite happen in the high yield market, which has actually increased its exposure to the highest quality part of the market, BBs.

As you can see in this chart, BBs now constitute almost 50% of the entire market, up over 10 percentage points from 2007 and 2008 levels. To be clear, not all high yield is created equally. It is the higher quality part of the high yield market where we see opportunity today.

[Airola] So Greg, you’re talking about investing outside of the Agg index and I guess specific to a Core Plus strategy, doesn’t that end up adding more risk to client portfolios?

[Shea] It certainly can, Kyle. The Core Plus universe is broad, and some managers add risk in ways that we don’t think are necessary for a bond fund. Let me explain. They go outside the index and add emerging market debt exposure, which can carry a much different risk profile than US domestic bonds. They layer in derivatives, which can also add volatility and counterparty risk, or they invest in the levered loan market, AKA bank loans. A market similar to the investment grade market has increased and taken more credit risk over the last 15 years.

Our Core Plus is different. We seek to take advantage of inefficiencies such as small issue sizes that are not on the radar of large managers and are tough to get meaningful exposure to in those passive bond strategies, as well as misrated securities, not taking the rating agency’s word for it, but instead defining the quality through our own credit work, not by what rules-based index that falls in. And this is the opportunity I highlighted and touched on earlier.

Let’s look at a side by side comparison on what you can get in that lowest rate rating category in the investment grade corporate market, the BBB index. First, what you can get in the highest rating category, the BB index of the high yield market. Looking at this comparison, you see today that an investor gets close to the same discounted bond price going in on the investment, but can pick up over 1% in both yield and spread while decreasing exposure to interest rates or future interest rate increases by over three years, which we feel is very compelling in today’s market. In many cases, these BB issuers have good balance sheets and liquidity, but are smaller and out of index compared to their BBB counterparts, and we’re exploiting that inefficiency today.

[Airola] Troy and Greg, thank you for your insight. This is an exciting time within fixed income. And again, to reiterate, over $40 billion in flows into the Core Plus space this year alone. Bonds are back and a great opportunity for active management within a Core Plus portfolio. So with that, I want to thank everyone for joining us today. If you have any questions on our active approach within fixed income and our Core Plus capabilities, please reach out to your Segall Bryant and Hamill sales contact or find us online at sbhic.com. Thanks.