Over the past decade, there has been much debate between active and passive investing. Many modern-day investors, including fixed-income investors, have shifted to the passive investing approach. Although this approach has worked well for equities, it has generally fallen behind for fixed income as active fixed income managers generally outperform their passive counterparts. Active fixed income management vs. passive fixed income management should not be viewed in the same light as active equity management vs. passive equity management. Differences in how fixed income securities trade, the higher number of overall securities, and intensified dependence on liquidity creates specific headwinds that passive fixed income managers do not account for. With that said, bond/credit indices do not accurately reflect the opportunities within their relative space. Furthermore, bond indices have fundamentally flawed constructions that do not reflect the intricacies of the bond market.
Some of the flaws of bond/credit indices are:
- Higher duration risk exposure
- More interest rate sensitivity
- Poor index weighting methodologies (index weighting by debt outstanding)
- Inaccurate importance assumption on the new issuance bond market amid the finite life of bonds
- Large dependence on historically inaccurate ratings from credit rating agencies
- Incomplete representation of bond trade activity (most bonds trade over-the-counter: dominated by buyer and seller negotiations)
This creates ample opportunities for active fixed income managers to find arbitrage outside of indices.
Some of the main advantages of active fixed income strategies are:
- Ability to decrease interest rate sensitivity and control duration risk (modified duration of the Bloomberg Barclays U.S. Aggregate Bond Index is 6.44 as of 11/30/20)
- Ability to find yield in low-yield environments (highlighted here: Finding Yield in a Low Yield Environment)
- Optimize the trade-off between duration exposure and yield capture
- Leverage company-specific credit fundamentals, identifying misrepresented bonds with fortress balance sheets
- Ability to mitigate market volatility
- Agility to capitalize on opportunities created by dynamic economic and policy shifts as seen with the recent bear steepening environment (highlighted here: Deciphering a (COVID-19) Vaccine Driven Economic Recovery: An Equity and Fixed Income Perspective).
The argument for passive fixed income management falls short
Although the active vs. passive debates rage on as investment flows suggest passive investing has been winning, a clear line must be drawn between equity passive investing principles and fixed income passive investing principles. Equities and bonds are fundamentally different. Bond investors have varying objectives, with the bond securities having different trading dynamics, resonating significance on bond new issues, and increasing skewness of individual bond returns vs. individual equity returns.
Additionally, bonds have significantly more securities than their equity counterparts. More securities create more market insecurities. Therefore, the argument for passive fixed income management falls short. As seen throughout 2020, active fixed income managers have the flexibility to take advantage of the nuanced fixed income market and outperform the passive, flawed bond indices.