[Challenging established investment processes and tools has played a critical ongoing role in the evolution of the asset management industry. Sometimes, just looking at traditional ways of investing from a different perspective is enough to open up better risk management approaches and more investment opportunities. Such may be the case in many traditional portfolio construction efforts to place an over-reliance on certain bond indices, such as the Bloomberg U.S. Aggregate Bond Index (AGG), as key components of an investment portfolio. A closer look at using indices illustrates the need for constant reappraisal.
Approximately 54% of the $52 trillion U.S. bond market is missing from the Agg, specifically excluding corporate high yield and vastly underweighting other categories like municipals and non-mortgage asset-backed securities. The top two components of the Agg – Treasuries and Mortgage-backed securities – equal over two-thirds of the index holdings and have historically exhibited extremely high correlation rates of 90%. These facts combine to suggest that diversification of risk and opportunity in the U.S. fixed income markets might be better found elsewhere.
To better explore bond market exposure in an investment portfolio from a different perspective, we were introduced to Nolan Anderson and Thomas Carney of Omaha, Nebraska-based Weitz Investment Management and co-Portfolio Managers of the Weitz Core Plus Income Fund and the Short Duration Income Fund. We asked them questions to learn from their investment experience on how to approach investing in the bond market with a wider net and a sharper risk/reward lens.]
Hortz: How does an index like the Agg gain such prominent positioning and usage in representing an asset class, like fixed income?
Carney: Well, the Agg as an index has been around the longest. It was started back in 1973 by a couple of gentlemen from a boutique investment bank called Kune Loeb and Company. They created two indices at the time – one focused on US government bonds and the other one on investment grade corporate bonds – which in 1979 were blended to form the Government Credit Index. But in 1986 mortgage-backed securities were added to the index, and it was renamed the US Aggregate Index. It was later acquired by and renamed the Barclays Capital Aggregate Bond Index, and then Bloomberg acquired that index in 2016.
Through all that, it has held its position because it is simple to use on an allocation basis. It is an easy way to gain access to the US bond market across US government securities, investment-grade corporate bond securities of certain sizes, and mortgage-backed securities. It is really a three-legged stool. And investors have found it pretty easy to work with, even making ETFs to be able to get in and out of it on an intraday basis. To me, that is why the Agg has risen to such a prominent position.
Hortz: Why does it seem then that these investors using indices in the bond markets have been resistant or have a hesitancy to deeper, more expansive diversification like they may have pursued in the equity markets?
Carney: Without speaking for others, I think it is a case where investors did not necessarily believe there was a lot of value to be had beyond the Agg. If people just wanted great exposure to the US bond market across government, mortgages, and corporates, perhaps they thought there was no way they could possibly outperform over the long term by doing a more active approach. So maybe they just take a passive approach to fixed income using an index and then focus on winning on the equity side.
Anderson: I have a simple answer and a complicated answer. The simple answer is you have really not needed anything else beyond the Agg. Right up until last year, there was not a lot of blood in the streets with fixed income. Outside of the eighties, you had negative correlations between stocks and bonds most of the time. When stocks went down your bond allocation went up, and when the bond allocation went down, your stocks went up. Returns in the Agg until recently have been relatively strong. You really did not have any need for any other exposure. That’s a simple answer.
The complicated answer is most of the growth that has come in the fixed income markets that are away from the Agg – the asset-backed securities (‘ABS’) market, collateralized loan obligations, those kinds of things, they were there before, but they really became more prominent after the Global Financial Crisis. That is when the regulations of the banks changed. That is when you had issuers use the ABS market as a funding mechanism, which is also what made it really challenging because it happened on the back of the mortgage meltdown, on the back of the subprime mortgage crisis.
Subprime mortgages are structured products. They were manufactured horrendously and there has been a lasting negative connotation around structured products and asset-backed securities, when in fact, the reason why they are so attractive today is because of what happened with subprime mortgages. There was a “cleaning of the house”, if you will, around the rating agencies, investors, what credit enhancement really is, what structure is, and an alignment of interest with sponsors. The bottom line is that the structured products market broadly has evolved into a more investor-friendly market with better structural features and investor protections. So, we have actually benefited from that negative reputation around the space. That is why a big part of our portfolios today are invested in those areas. There are diversification benefits from using these investments that are away from the Agg. They are a big part of why some managers have performed reasonably well relative to the index more recently in this rising rate environment.
Carney: Let us dig a little further here. The bond market has been evolving and many indices are not capturing this evolution. The Great Financial Crisis and Dodd-Frank changed markets. Certainly in the banking industry, but it has also created what has transpired in the bond market today. There have been new types of bonds and new areas that are not being tracked by most indices because they are too new. That is an extremely broad, large bucket with trillions of dollars of investment opportunities. This large swath of the US bond market not covered by the major bond indices is being covered by active mutual funds, like us, and alternative investment managers.
Hortz: Can you give us some examples of these relatively newer areas of the bond market?
Anderson: Within the commercial mortgage-backed securities (‘CMBS’) market, in the last 10 years, there has been a market called the CRE CLO market, the commercial real estate collateralized loan obligation market. It does bridge lending. It will provide financing to sponsors that are buying an office building, industrial building, or multi-family building that needs a facelift. Take the example of an older apartment building. Someone comes in and buys it, puts new vinyl flooring, granite countertops, stainless steel appliances, slaps some paint on the outside, fixes it up, rents it at higher rates, and then either finances it in the CMBS market that I mentioned earlier or sells it. So, for every kind of commercial property you can think of, we have diversified exposures to that.
I think middle market collateralized loan obligations (CLOs) would be something else; direct lending, middle market CLOs. The largest part of the economy in the United States is the small mid-sized businesses of this country. They hire and employ the largest number of people, and those businesses are financed in the CLO market. That is something that has probably just been around for the last 10 years or so and has grown tremendously over the last five years. Anywhere you see large capital formation, large growth in raising capital, they are finding ways to finance it in the bond markets. It is basically the entire US economy.
You would never see that in the Agg. It is a form of financing that otherwise did not exist pre-Global Financial Crisis that bond investors like us can get access to. That kind of lending offers a tremendous amount of diversification for investors. In our portfolios, we also provide exposure to auto loans and equipment loans.
Carney: Private credit also really began to be a thing in the bond market. Again, Dodd-Frank had a lot to do with it, with banks being restricted. And now there is an enormous number of sponsors that are in the private lending area, many of whom we partner with in the middle market collateralized loan obligation area.
This is over a trillion-and-a-half-dollar area today, starting from almost zero in 2010; moving out of the banks into private hands that we now have the ability to access which is not represented either in the S&P or the public bond markets because these companies are private. Companies that might be very large, but they have no reason to go public, that we can be a senior lender to, in those capital structures, with partners that we have spent a lot of time with. We think it has represented a really unique opportunity for active fixed income investors to take part in.
Hortz: Are you comfortable in giving an example of a company that you partner with in this manner?
Carney: Lithia is a really good one because it is a crossover. This is a company that has unsecured outstanding bonds that you would find in the high-yield index. They are an issuer in the asset back market. Lithia, I believe is the third largest new vehicle automotive dealership group in the United States, after AutoNation and Penske Automotive Group, and the largest publicly traded, nationwide retailer of new and used cars. They sell cars and buy dealerships. They have a really good proven model of acquiring dealerships, integrating them into their system, and taking costs out. It’s a scale business and they are winning the scale race.
They decided, well, we sell cars and with most cars comes a loan. Why don’t we finance our own cars? So, they started a captive auto finance business called Driveway Finance, and they came to market for the first time in November of 2021. And one of our JP Morgan lead banking partners, that we do a lot of business with on the asset-backed side, said we should take a call with these guys. They are brand new to the market, but there might be some value here. We went out to meet the management team face to face, and we participated in their first deal. We liked it for many reasons. Now, fast forward almost three years and they have become a well-known name and are becoming a more frequent issuer in the market. Given our ability to evaluate and invest across the capital structure, we were able to buy investment grade BBB-secured auto ABS bonds at a wider spread than their high-yield corporate unsecured bonds.
By casting a wider net in the Lithia case, in the same business, you are finding a more attractive investment and that is what adds value in many ways. I would not be surprised if a large number of people that own Lithia in a high-yield fund, probably do not even know that they have an ABS program. We sit here with a wider dashboard than one that could only buy investment-grade corporate bonds, mortgages, and treasuries. We have continued to expand our dashboard and our circle of competence, and we have so many more things to look at and evaluate. As long as you do the work and have a larger menu of options, we think there are huge advantages for our shareholders.
Hortz: How would you explain or characterize your fixed income investment strategy?
Carney: We talk a lot about winning by not losing. Your mistakes in equity investing can get covered up by the really big winners, but that is not the case with fixed income. It is a lending environment where we have to minimize losses as well as we can. Added to that, we have a valuable flexible mandate, just speaking specifically about the Core Plus Fund, we can go seek and find value wherever it is. We have a much larger toolkit than many others that might be really focused on some sort of broad market environment. We are always mindful of liquidity needs and diversification, but we are not simply building portfolios based on this over/underweight mindset that many fixed income investors tend to do. We are a pure US dollar fixed income fund, with no derivative exposure. That makes it much easier for us to manage uncertainty.
Hortz: How would you describe your Short Duration Fund versus your Core Plus Fund?
Anderson: Almost everything we have talked about on our Core Plus Fund – be flexible, go anywhere, index agnostic – does apply with our Short Duration Fund with maybe one key differentiator. The duration profile we manage to in our Short Duration Fund is one and a half to three years. Our Core Plus Fund is three and a half years and beyond. If our Core Plus Fund is willing to really be concentrated in high conviction areas such that we could really differentiate ourselves at times, I have often labeled the Short Duration Fund as the guy at the plate who is just trying to get on base; really just playing small ball, moving around the bases.
The Short Duration Fund would be very heavily weighted toward structured assets, even more so than our Core Plus Fund whose job is to generate solid returns, being more of a total return vehicle willing to hit for power when it is appropriate. In many ways, they are siblings. They just have different sorts of athletic profiles in terms of what they are trying to do on the field.
Hortz: What should advisors know about assessing and managing the fixed income allocations in their client portfolios?
Anderson: Many investors feel they need bonds for income and diversification, and we will get our alpha on the equity side. Our message is that there is alpha to be had on the fixed income side. Active managers, like ourselves, have developed long-term track records of providing alpha after fees by going deeper into the bond markets and being flexible and nimble, with opportunistic research and strong risk management.
US businesses have changed the way that they finance themselves and borrow after the Global Financial Crisis. And if you are not paying attention to that, you are going to miss opportunities, both on the upside by casting a wider net and protecting against the downside with broader diversification that you cannot get by tightly tracking a bond index.