An experienced bond manager makes all the difference, says Legg Mason’s Thomas Hoops
Even with concerns about volatility and today’s low yields and tight bond spreads, opportunity abounds in fixed income. It is unlikely to be found through passive benchmark-tracking investments, however.
The best way to generate greater alpha opportunities in fixed income is through active management. Data from Morningstar show that the median active fixed income manager beat passive strategies over the past one, three, five, seven and 10 years. They have done so with only slightly more volatility, leading to higher Sharpe ratios, a measure of returns when adjusted for the riskiness of their bets. Essential stories related to this article Markets Insight Bond markets need to wake up to global upswing FTfm Bond funds attract $355bn in first five months of 2017 US Treasury Bonds Treasury bulls face test after September sell-off Expanding the time horizon when comparing active managers with the Bloomberg Barclays US Aggregate index does not change the results. eVestment, the data provider, includes returns for 147 so-called core full managers since the inception of the US Aggregate, with up to 40 years of data for some. More than 95 per cent outperformed the US Aggregate, and the median manager delivered gross returns over 1 per cent per year (114 basis points) above the benchmark. At Legg Mason, our investment affiliates are active managers, so we admit our bias. We are also not naive. Beating the benchmark, generating income and limiting downside risk can be daunting tasks. However, returns greater than “market” in a low-growth, low-inflation environment will be necessary to satisfy the increasing demands of investors for the income they need, particularly as they reach retirement. At the same time, investors expect strong risk controls and defensive performance. Fortunately, there are structural advantages in fixed income that can give active managers an edge. Fixed income benchmarks may be poorly constructed. Bond indices typically assign larger weights to countries and companies that issue more debt.
Passive products thus increase exposure to credits of potentially deteriorating quality. They are fundamentally different than market-cap equity benchmarks that have underpinned the bulk of passive flows in recent years. Fixed income benchmarks have high concentrations of government and government supported debt. US Treasury bonds constitute 37 per cent of the US Aggregate, while agency mortgages and debentures comprise another 31 per cent. For the Barclays Global Aggregate, government and agency-backed bonds represent 54 and 17 per cent, respectively. Yields on many of these bonds are unattractive, at or near historical lows, and nearly all the world’s negative yielding debt is included in the Global Aggregate. Moreover, government-backed bonds tend to be highly liquid, so passive investors may be paying premiums for unneeded liquidity. Fixed income benchmarks exclude a large portion of the investable universe. Because the US Aggregate does not include bonds not blessed by the rating agencies, inflation-linked bonds and foreign currency bonds, passive products exclude roughly two-thirds of the US fixed income market. This can limit returns and diversification. Major bond market participants often act for reasons other than profit maximisation. Central banks have growth and inflation mandates; finance ministries maintain currency reserves; and financial institutions often manage against book yield or regulatory constraints. It has been estimated that over half of the global bond market is comprised of such entities. Their willingness to forego profit maximisation can create opportunities for experienced active investors. Fixed income benchmarks have frequent turnover. Bond markets are highly dynamic, characterised by steady streams of new issues, repayments, maturities and rating changes.
Over the past three years, the turnover rate for the US Aggregate has been roughly 40 per cent, while the S&P 500 has experienced less than 5 per cent. This year 1,614 securities have been added and 2,171 have been removed from the US Aggregate. Trading costs, potentially substantial, can disadvantage passive investors. Active investors have a timing advantage. Active managers can trade in the primary market at any time to obtain new issues at yield premiums. These are typically not available to many passive managers, who buy their mandates trade only at month end. Simply put, fixed income markets give active managers numerous advantages over passive index investing. So as investors worry about the Great Unwind and the effects it might have on their income portfolio, take heed, and solace, if you are investing with an experienced active bond manager.