High-yield bonds and emerging market debt are among the instruments that portfolio managers are using in the current post-recession environment, as the U.S. Federal Reserve is poised to begin tapering its bond purchasing programs.

In a rising rate environment, as occurs in the recovery phase of the economic cycle, high yield bonds would be expected to outperform many other fixed income classes.

“High-yield has outperformed all fixed income assets,” said Martin Smith, senior portfolio manager at Penn Capital Management, at a press briefing held by American Beacon Advisors. Penn Capital is a sub-advisor to the American Beacon High Yield Bond Fund.

“The benefit of high yield is that it is a short duration asset,” Smith said. “The best case scenario for high yield is a gradual improvement in the economy.”

High yield bonds often have relatively low because they tend to have shorter maturities; they are typically issued with terms of 10 years or less and are often callable after four or five years.
Low duration, or sensitivity to changes in interest rates, tends to lower volatility. Generally, high yield bond prices are much more sensitive to the economic outlook and corporate earnings than to day-to-day fluctuations in interest rates.

Penn Capital’s Opportunistic High Yield strategy seeks to generate residual returns through tactical allocation of capital toward the best risk-return opportunities available in the U.S. dollar denominated high-yield corporate debt market.

The portfolio primarily invest in U.S. dollar denominated, cash paying debt that are rated in the upper and middle tiers (BB-B rated) of the corporate debt marketplace. Penn will tactically invest in debt rated below B, stressed debt, distressed debt, convertible bonds and convertible preferred securities in situations where, in its view, the return opportunity exceeds the risk of downside loss.

Unconstrained bond strategies seek to capitalize on inefficiencies and mispriced securities in the global fixed income and currency markets, are also likely to benefit from a rising interest rate environment. “The positive run for traditional, long-only investors may be coming to an end, with an improving economic outlook pointing toward higher bond yields,” said Jack Flaherty, investment director at GAM International Management, which is a sub-adviser to the American Beacon Flexible Bond Fund.

An unconstrained fixed income strategy provides the investment manager with the flexibility to invest across a wide variety of asset classes to generate performance. “As a flexible bond fund, we are not constrained by benchmarks,” Flaherty said. “More divergence among economies creates opportunities from a global perspective.”

GAM’s Unconstrained Bond strategy invests across a range of markets and instruments: G13, investment grade, emerging markets, high-yield and convertibles.

“Like high-yield bonds, convertible bonds do well in a rising rate environment because of their high correlation with equities,” Flaherty said. “Over time, that has been one of the best performing asset classes.”

Meanwhile, Cerulli Associates, a Boston-based global analytics firm, has projected the U.S. institutional market to increase 30% to $19 trillion in assets within the next 5 years. Cerulli defines the institutional market based on the identity of the end-client, classifying assets as institutional only when the asset manager’s end-client is an institution.

“As of year-end 2012, the institutional market held $14.5 trillion in assets under management,” states Michele Guiditta, associate director at Cerulli. “And, with more than $4.0 trillion in assets, private defined contribution remains the largest U.S. institutional market.”

Cerulli highlights an opportunity for asset managers who have shifted their focus to DC to leverage existing relationships with corporate DB plan sponsors, allowing them to win DC mandates and potentially extend to custom target-date solutions.