This Strong Bond Fund Thinks Outside the Box

The following is our latest Fund Analyst Report for BlackRock Total Return (MDHQX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

BlackRock Total Return's approach combines rigor and out-of-the-box thinking. Add in BlackRock's deep human and tech resources, and its cheaper share classes merit a Morningstar Analyst Rating of Gold, while some more-expensive ones earn a Silver rating.

The aforementioned rigor resides in how the managers make the most of the firm's deep resources to produce scrupulous research, both macroeconomic and bottom-up, and conduct thorough risk management. This strategy's custom-built risk dashboard leverages Aladdin, the firm's risk-management system, to decompose the strategy's risks in a variety of ways. Every system that relies on historical data is exposed to risk that the future won't be like the past. Nonetheless, this one helps its managers monitor the distribution of risks, and they rely on it extensively.

That's notable because the strategy, whose benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index, takes on a variety of out-of-index bets, including high-yield bonds and nonagency mortgages. It aims to maintain some balance between those risks--no single bet is supposed to dominate--and since the arrival of lead manager Rick Rieder in 2010, the strategy has shown itself somewhat more circumspect in taking on credit risk than some more-aggressive intermediate core-plus bond Morningstar Category peers. The out-of-the-box element involves correctly identifying big trends affecting markets and positioning the portfolio accordingly. This is more of an art than science, but Rieder is a voracious consumer of data and labors to synthesize large amounts of information into actionable themes.

The resulting returns have been strong. The strategy stumbled a little in 2011, Rieder's first full calendar year on the strategy, and in 2018, when an early defensive positioning pushed it to the bottom third of its distinct peers. Overall, though, its long-term performance has been solid thanks to smart positioning across sectors and solid risk management. Expect that to continue.

Process | High
This strategy's approach is a two-step effort held together by effective risk controls. Its well-thought-out conception and meticulous execution support a High Process Pillar rating.

Rick Rieder and Bob Miller determine the top-down layer of the approach. Their approach is driven less by standard fixed-income drivers like monetary policy but rather by an in-house framework, which emphasizes concepts such as broad trends that will typically last between two and four quarters like synchronized global growth and convexity, meaning asymmetry of outcomes. Rieder and Miller like situations in which the outcomes are skewed, meaning some outcomes are more likely than others; they want to bet on the more likely ones.

Once the main themes have been determined, the managers farm out security selection and implementation to relevant sector teams but surgically monitor the portfolio's risk distribution through a custom-made Aladdin-based tool. The strategy is a core-plus offering, meaning it can go beyond its Bloomberg Barclays U.S. Aggregate Index benchmark. Its generic prospectus risk-control guardrails give the managers a decent amount of flexibility. While they have been close to the 20% junk-rated cap in the past by pushing the below-investment-grade exposure up to 18.3%, the emerging-markets exposure has historically been maintained below 9%, despite the 20% prospectus limit.

It is useful to view the portfolio via two perspectives. One is through the lens of broader manager-implemented themes; the other is through a range of tools and bets that share some likeness to the way many hedge funds are managed.

In terms of broader themes, as of Oct. 31, 2020, the managers brought the duration up to 0.1 year below its benchmark's and reduced exposure to the front end of the yield curve, after the Federal Reserve's early 2020 rate cuts caused these positions to lose their hedging efficacy. The team brought down exposure to municipal bonds (0.9%) and U.S. investment-grade credit (26.7%) given less compelling valuations after their strong rebound from the March sell-off and selectively added to U.S. high-yield credit (7.8%) and emerging markets (9.5%), the two largest overweightings at the end of October 2020. Within emerging markets, the managers favored high-quality hard-currency corporate debt as a source of attractive income.

The strategy's hedge fund flavor was reflected in its structural, albeit decreasing, use of leverage (6.5% as of Oct. 31, 2020, versus twice as much on average over the past five years) and a panoply of holdings that are unusual for an intermediate core-plus bond strategy. Admittedly tiny, these holdings could include options on the S&P 500, VIX, and foreign currencies; volatility futures; and high-yield exchange-traded funds.

People | High
This management team is experienced, its resources are extensive, and its reach is global. It earns a High People Pillar rating.

Rick Rieder, the strategy's lead manager, is BlackRock's CIO of global fixed income. He joined BlackRock in 2009 after having spent the majority of his career at Lehman Brothers and became a manager here in 2010. By his own admission, Rieder's priority after his pure investment work is the identification and acquisition of investment talent, and he has done a fine job on this front. Comanager and head of Americas fundamental fixed income Bob Miller, who had spent most of his career at Bank of America, joined Rieder in 2011. Rieder and Miller are the senior members of the management team; David Rogal, who became a named comanager in January 2017, focuses on day-to-day operations and management of the strategy.

The team taps into BlackRock's well-staffed and global fixed-income platform. With close to 500 fixed-income investment professionals across the globe, the pool of expertise is wide and deep. The extensiveness of the firm's resources at this team's disposal displays a strength that few peers can compete with. The strategy has two dedicated risk-management specialists but is also indirectly supported by a vast organization dedicated to maintaining Aladdin, the firm's flagship risk and portfolio management system.

Parent | Above Average
BlackRock's advantages outweigh its disadvantages; it earns an Above Average Parent rating.

BlackRock is a $6.4 trillion money manager with unparalleled scale and influence. It's a market-leading and standard-setting passive investor with iShares. It has a deep and talented fixed-income team. Its Aladdin software is a vital risk analysis and portfolio management tool for the industry. BlackRock Financial Markets Advisory has secured the trust and mandates of many governments, including the Federal Reserve's pandemic-inspired debt-buying program. BlackRock also has designs on alternative, factor, and private equity investing and has pledged to double its environmental, social, and governance ETFs and incorporate ESG in all its strategies. Fees also have improved.

Its ascent has had setbacks, though. Multiple attempts to revamp its active equity lineup have yet to produce the revival that fixed income achieved. The firm has launched some gimmicky strategies. In 2019 and 2020, it fired two executives and a closed-end fund manager for violating company code of conduct policies, showing how difficult it can be to foster and enforce an ethical culture at such a behemoth. While it preaches ESG's virtue, it has often sided with management in ESG proxy votes.

BlackRock is not the best at everything it does, but it realizes the best way to serve its public shareholders is to fulfill its fiduciary duty.

Performance 
Performance under the current management has been strong despite starting on a weak note in the first full calendar year of Rick Rieder's tenure and a difficult year in 2018.

The strategy's sources of extra return have been diverse, which lends credence to Rieder's claim to be "maniacal" about diversification of risks. In 2011, a below-investment-grade stake and shorter-than-benchmark duration dragged the strategy into the bottom decile of its intermediate core-plus bond category. After six consecutive years of solid returns driven by multiple levers, the strategy underperformed its benchmark and two thirds of its (distinct) rivals in 2018 because of its defensive stance. However, it bounced back in 2019 when, driven by contributions from almost all performance levers, the strategy beat two thirds of its competitors. While landing in the middle of the pack during the late February to late March 2020 sell-off, the strategy bounced back stronger than most peers, driven by stakes in agency mortgage-backed securities and its rates and yield-curve positioning, to outpace two thirds of its rivals for the year to date through October 2020.

Over Rieder's tenure from September 2010 through October 2020, the strategy landed in the best third of its category on both an absolute and a volatility-adjusted basis (as measured by Sharpe ratio), thanks in part to solid risk-management controls.

Price 
It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its category's second-costliest quintile. That's poor, but based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we still think this share class will be able to overcome its high fees and deliver positive alpha relative to the category benchmark index, explaining its Morningstar Analyst Rating of Silver.