Active Management Could Be Difference Maker for Fixed Income Investors

With the Bloomberg US Aggregate Bond Index slumping amid interest rate tightening by the Federal Reserve, investors can be forgiven if they’re quick to assume nothing is working in the bond market in 2022.

To say “nothing” is working in the world of fixed income isn’t 100% accurate, though if “working” means “appreciating,” then the options are indeed limited. There’s plenty of “less bad” in bonds to go around, but many broad-based passive strategies are either lightly exposed to those segments or have no allocations to them at all.

In other words, for all the criticism active management endured in recent years, today’s fixed income climate is highly conducive to fixed income investors considering active mutual funds and exchange traded funds.

For novice investors, evaluating active management could be pivotal in a treacherous fixed income environment on the basis that an index-based strategy will only deliver the index’s returns minus fund fees while active managers seek returns in excess of a particular benchmark.

Good Reasons to Consider Active Fixed Income Today

Obviously, bond investors’ primary concern today is duration risk or interest rate risk. Put simply, longer-dated bonds are more sensitive to changes in interest rates. That explains why long duration Treasuries were almost “easy money” from late 1980s well into the current century – interest rates dramatically declined.

That sword cuts both ways as fixed income investors are finding out today. Point is active managers can more nimbly adjust duration risk to reflect what’s happening now and what could happen in the not-too-distant future. Conversely, a passive bond fund’s duration is what it is and material short-term changes to that number are rare.

“Active managers can consider a much broader spectrum of potential investments, and can act on informed assessments and market outlooks, to construct a portfolio that may differ from the benchmark-driven exposures of a passive strategy,” according to Fidelity research. “These advantages have allowed the majority of active managers in various bond fund categories to outperform fixed income benchmarks.”

In addition to rate risk, the point about “a much broader spectrum of potential investments” is crucial in its own right. Meaning many broad bond benchmarks, such as the Bloomberg US Aggregate Bond Index, really aren’t that broad and nor do those instruments position investors to capitalize on credit opportunities.

A passive fund tracking the Bloomberg US Aggregate Bond Index allocates over two-thirds of its weight to Treasuries and mortgage-backed securities (MBS). Over 84% of its holdings are rated AAA, AA or A. Translation: While it’s nice there’s essentially no credit risk here, there are also no credit opportunities. That leads to a low yield and limited upside potential for investors. Conversely, an active bond fund can expose investors to more credit opportunities, potentially while limiting risk, creating a more robust income stream in the process.

Intentionality Matters, Too

Another point for investors to ponder is composition. As noted above, the Bloomberg US Aggregate Bond Index has to have large exposure to U.S. government debt and limited allocations to higher-yielding, supposedly riskier fare.

However, an active bond fund doesn’t have to follow suit, meaning some of these funds offer compelling stories at the holdings level.

From year-to-year, “different sectors of the bond market have had a range of returns relative to the aggregate market overall. An active portfolio manager may seek to generate excess return by overweighting (holding more of) sectors the manager perceives to be likely to generate better returns, while underweighting (holding less of) the remaining sector,” adds Fidelity.

Bottom line: In the world of equities, active managers took plenty of lumps over the years. Rightfully so in many cases. But in this climate, investors should not transfer active equity performance (or lack thereof) to bond managers. Active could be a difference maker for bond investors for the foreseeable future.

Related: How to Think About Shortening Equity Duration