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Over the past several years, many investors have moved from active to passive core fixed income strategies, believing these markets offer fewer idiosyncratic risks to exploit than equities and are too efficient for active managers to generate alpha. Yet passive approaches have frequently underperformed active core plus fixed income strategies and may expose investors to several forms of unintended risk. Active fixed income management not only offers the potential for enhanced returns but can also add value by aligning an investor’s objectives with risks in several key areas — market structure, credit deterioration, dislocations, and dispersion — where index-tracking approaches may fall short.1
Advocates of index-replicating fixed income strategies argue that active managers cannot consistently outperform the Bloomberg US Aggregate Bond Index (the “Agg”), net of management fees. Yet active core plus fixed income approaches have historically fared well against the index over most time frames during the past 20 years (Figure 1).
Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit. Indeed, active managers have many other levers for seeking to generate alpha, such as sector rotation, out-of-benchmark allocations, duration positioning, security selection, and (in the case of global strategies) country and currency selection. These noncredit levers may also mitigate drawdowns during credit-adverse environments.
That said, credit overweights have clearly helped boost excess returns delivered by active managers over most periods — the great exceptions in the past 20 years being the global financial crisis (GFC) and COVID pandemic. Recouping of the spread widening emerging from these drawdown periods compensated for active managers’ shortfalls versus index returns in 2008 and early 2020. While the median active manager’s performance versus the index tends to be positively correlated to credit spreads — outpacing the index when spreads narrow and lagging when spreads widen — periods of underperformance have often been short-lived and typically outweighed by longer stretches of outperformance.
Fixed income markets tend to be fragmented and opaque, prone to experiencing volatile liquidity. However, these features may benefit thoughtful investors by increasing the premia they can earn through portfolio implementation and active management (Figure 2).
Fragmented: Unlike equity markets, there is no “central” fixed income exchange. Instead, securities are still traded “over the counter” (OTC). This often requires a trading desk to strategically plan how it will either buy or sell a bond, allowing the implementation aspect of investing to potentially add value. Moreover, issuers may have different bonds in various parts of their capital structure or in varying currencies and maturities. A single corporate or government issuer may have numerous individual bonds, each with different terms and conditions. That can mean the risks and rewards differ as well. A passive exposure does very little to distinguish among those individual bonds.
Noneconomic actors: Some key participants in fixed income markets are looking to achieve objectives other than a rate of return. These include central banks and the US Treasury, along with commercial banks and insurance companies that may be subject to investment constraints imposed by the regulatory framework. Hence, these counterparties are often not trading based on valuations, leaving room for active investors to purchase or sell bonds at opportune times.
Liquidity and balance sheet: Reductions in dealer balance sheets following the GFC have made liquidity more variable across fixed income markets. Given that there is no central fixed income venue, investors rely on dealers to serve as counterparties for trades and to hold inventories of bonds. The reduced ability of a dealer to “intermediate” or serve as a place to store inventory means bond prices can be influenced by the noneconomic actors, providing the opportunity for an active investor to supply liquidity when traditional intermediaries cannot and to do so more effectively than passive investing.
Implementation: Fixed income markets provide a number of ways for skilled practitioners to add value through implementation, many of which are not replicable in passive terms. Issuer, CUSIP, and maturity are all important facets of a decision. In addition, active investors can decide whether the exposure looks better in cash (“funded”) format or through derivatives such as futures (“unfunded”) and can seek to exploit differentials between the two. Similar dynamics exist for currency markets, where lending dollars via the cross-currency basis market may deliver robust risk-adjusted returns. Over time, these and other tactics have often translated into superior results versus passive exposure.
An important feature of credit is its asymmetric risk profile: The market value of a bond can fall much more than it is likely to rise. (In other words, credit spreads can widen much more than they can narrow.) An active portfolio manager can play a vital role in anticipating turns in the credit cycle and avoiding downside risk. In particular, fundamental research can help managers identify deterioration or improvement in a credit before the rating agencies do, and even before the shift is priced in by markets.
A prominent concern among investors is that lower-rated credits now comprise a larger share of the investment-grade credit universe than in the past (Figure 3). Deeper analysis of a company’s leverage ratios is essential to understanding whether or not the company’s ability to service its debt is negatively impacted by higher debt levels. At the very least, higher leverage should be a clear warning sign for credit teams to investigate a company’s earnings and free cash flow, its plans for asset sales and dividends, and how committed its senior management is to investment-grade ratings. An experienced portfolio management team that can go beyond the headlines may be able to identify opportunities and risks.
Index providers’ rules for credit downgrades can also cause passive strategies to trail active ones. In the Bloomberg Investment Grade Corporate Index, securities downgraded by at least two of the three main credit-rating agencies (Standard and Poor’s, Moody’s, and Fitch) must exit the index by the end of the month in which they are downgraded. But deteriorating credits often sell off before they are downgraded as investors anticipate the downgrade. Consequently, the indices are often forced to eliminate such bonds after they have fallen in price.
Dislocations can occur across all segments of fixed income markets, driven by various structural imbalances (e.g., growth in debt stock versus reduction in market-making activities) that leave securities across spread sectors vulnerable to bouts of illiquidity. These dislocations — and responses by policymakers to them — can create opportunities for active managers.
Dislocations are not a new phenomenon, and we believe they could be a pervasive feature of fixed income markets. Over the past decade, we have seen an increasing frequency and volume of dislocations caused by a growing number of structural imbalances in fixed income markets (Figure 4). These structural imbalances leave fixed income assets highly vulnerable in periods of market stress, both at a macro and micro level. While they can represent a serious challenge for traditional fixed income investing, these imbalances have created a dislocation seam for aptly resourced core plus bond managers to identify and seek to exploit.
In our view, existing and growing structural market imbalances should lead to more frequent and severe disruptions on a go-forward basis. We believe that investors with patient and opportunistic capital may be able to take advantage of these market dislocations, creating the potential for attractive return outcomes. Active managers can seek to generate returns from the periodic bouts of volatility that we believe are now endemic in fixed income markets.
Opportunities shift over time and risk postures should not remain static at different stages of the business cycle. Unsynchronized economic, interest-rate, and credit cycles lead to inefficiencies that often create these opportunities. The best way to identify and capture these inefficiencies is by using diversified independent sources of alpha.
Active managers may find more opportunities to add alpha when dispersion is elevated. At wider spread levels, indiscriminate investors may be rewarded simply by increasing portfolio beta, whereas when spreads are tight, a greater emphasis on discerning credit selection is prudent. This is especially true in today’s environment as durations have extended over the last two decades and spreads are at the tight end of their historical ranges. There is much less margin for error to cushion against moves up in rates/spreads or credit-selection missteps.
But that is not to suggest opportunities are not ripe. The recovery across spread sectors has been swift relative to past crises, but far from uniform. Figure 5 illustrates our return forecasts across a core bond plus opportunity set, which assumes spreads retrace 50% of the way toward their long-term average over the ensuing year.
We observe a number of sectors whose fundamentals still appear underappreciated (notably select parts of the credit and structured finance universes) and which could potentially tighten further though we also believe it prudent to maintain a larger-than-typical reserve of high-quality, liquid assets so that we can exploit dislocations that will likely occur in the months ahead.
To summarize, we believe actively managed fixed income portfolios have several distinct advantages over passive approaches:
1We recognize that passive investing is not exactly the same as index-tracking. Passive investing features low turnover of portfolio securities compared to active approaches, resulting in relatively lower transaction costs. A low-turnover approach may be perfectly consistent with an investor’s objectives. However, to simplify terminology, this paper uses “passive” and index-tracking” interchangeably.
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