How This Top-Performing Bond Fund Is Navigating a Tricky Market
Frost Investment Advisors isn’t a household name like fellow bond fund managers Pimco or BlackRock. But perhaps it should be.
The firm’s $4.2 billion Frost Total Return Bond fund has completely dominated its Morningstar intermediate core-plus bond fund category over the past three, five, 10, and 15 years, beating over 95% of its peers in each period. In a weak time for bonds overall, the fund has delivered a 6% three-year annualized return and 3.1% over five years. By comparison, the average fund in the group has produced a measly 0.3% annualized return over the past five years, and the $398 billion Vanguard Total Bond Market Index exchange-traded fund has notched an even worse minus 0.1%.
The key to the Frost fund’s success has been lead manager Jeffery Elswick’s astute application of a flexible strategy. “If our view is that the bond market is going to deliver negative returns over the next 12 months, we give ourselves large latitude to minimize that downside in whatever way we can,” he says.
Elswick’s 12-month outlook on interest rates and the economy affects how much duration risk—a measure of bond interest-rate sensitivity—he will take, as well as the kinds of bonds he will own. Although the fund can hold any U.S. bond, he limits its exposure to high-yield bonds with low credit qualities to no more than 25% of the portfolio, since junk bonds increase a fund’s correlation with the stock market. As of March 31, the fund was only 4.9% invested in high-yield bonds, as Elswick doesn’t find their yields justify the additional credit risks.
The 2022 bond downturn and the 2023 recovery show the advantages of such flexibility. At the start of 2022, the U.S. Treasury market was poor from a risk/reward perspective because of low rates, Elswick says. He shortened the duration of his portfolio to a range between 2.5 to three years while that of the typical fund in his category was five to six years. Bond prices move inversely to interest rates, and the longer a bond’s duration, the more sensitive it is to rate moves. As inflation and rates spiked in 2022, the average core-plus bond fund fell 13.3%. Frost fell only 5.5%.
“I describe 2022 to our clients as our best year in 20 years and our worst year in 20 years,” because the fund isn’t supposed to lose money, Elswick says. Yet in 2023 the fund also outperformed its peers and benchmark, rising 8.4% because of astute individual security selection and the manager having increased the duration to four years.
Currently, the fund’s duration is 5.4 years, which, “versus the prior 10 years, is on the very high end and much closer to our benchmark duration,” Elswick says, referring to the Bloomberg U.S. Aggregate Bond Index. “We’re of the view that the U.S. economy is slowly normalizing and that money-market rates are not going to change appreciably over the course of the next year.” He expects the yield on the 10-year Treasury note will largely be range-bound between 4.4% and 4.6%.
Although the Iran war is a continuing concern vis a vis inflation, which drives interest rates, oil and other commodities “are actually lower than where they were a couple of months ago,” he says. “Also, U.S. tariffs on trade peaked around October of last year, and that is a tailwind for lower inflation.” For this reason, Elswick expects the Federal Reserve either not to change interest rates in the next year or to make one small cut by year-end.
In such a range-bound environment, Elswick wants to collect the coupon yield on high-quality bonds. But instead of Treasuries, he’s favoring higher-yielding securitized debt, primarily mortgage-backed bonds guaranteed by government agencies such as Ginnie Mae. A stable-rate environment is good for mortgage bonds as declining rates lead to more homeowners prepaying their mortgages and refinancing them with newer ones at lower rates—good for homeowners but less so for investors. Meanwhile, higher rates hurt all fixed-rate bonds.
Currently, 53% of the fund is in securitized debt, versus 34% for the average fund in its category and only 21% for the Vanguard index fund, according to Morningstar. The highest-quality agency debt yields about 1.2 percentage points above comparable Treasuries.
Elswick will also hunt for value in lower-quality corporate debt—recently 17% of his portfolio. He holds beleaguered aircraft-maker Boeing’s bonds, for example, which mature in 2064 and have a coupon rate of 7.1%. But Elswick purchased the issue at a significant discount to its face value, so it yields even more.
“We’re always searching for ideas that a lot of folks just don’t want to touch,” he says. “Boeing is the perfect example of that. We started to add to Boeing when they were having problems with their new Dreamliner [aircraft]. The market really beat the name up more than what we thought was justified.”
He also recently purchased bonds from software company Oracle, which has suffered from leveraging up its balance sheet to build data centers. S&P Global gives Oracle bonds a BBB- rating —investment-grade, but only one notch above junk bonds. Yet the bonds have been trading at a discount, with higher yields equivalent to BB-rated credits.
“This is still one of the premier companies in its industry,” he says. “The management team has said pretty firmly that they want to continue to keep the company at investment-grade-rated levels.”
The fund generally doesn’t invest in derivatives, such as swaps or index futures, which larger competitors like Pimco do for liquidity purposes. Elswick doesn’t like the leverage and counterparty risks derivatives add. “If we were running a trillion dollars like a Pimco, we almost certainly would have to do something different,” he notes.
Instead, Elswick employs a team of 10 analysts and traders to scour the market for individual bonds. For this, the fund charges a 0.71% expense ratio, which is higher than the Vanguard ETF’s 0.03%. If you have a Charles Schwab account, you can buy the institutional share class, FIJEX, which has a more attractive 0.46% fee, for a $1 minimum. Elswick also says a low-fee ETF share class of the fund may be forthcoming.
Maybe that will attract more investors’ attention.