Fixed income investing: the active advantage

Key takeaways 

Lower-fee active managers:

• Have exhibited a better risk/return trade-off over the past 10 years
• Manage interest rate sensitivity through active duration and yield curve positioning
• Can expand the investment universe to include higher yielding sectors with potentially less interest rate sensitivity
• May reduce credit risk through fundamental and quantitative research; sector and security selection; and tactical trading

Active fixed income strategies may offer investors numerous advantages over passive index strategies, providing enhanced risk-adjusted performance potential. Investors are still seeking risk-managed returns in the current high inflation and rising rate environment, and we believe active management for fixed income can better help investors pursue their goals. The advantages become all the more significant as we consider the flawed nature of issuance-based fixed income indexes and the long-standing segmentation of indexed markets.

Active management can be used in any environment

We believe actively managed bond strategies can help manage portfolio risk while enhancing returns, particularly in today’s rising interest rate environment. Active sector rotation, bottom-up security selection and interest rate (duration and yield curve) management can all create opportunities for investors to add value that are simply not available in passively managed strategies.

One might assume that index mutual funds would match the risk and return characteristics of their benchmarks, but on average these funds have exhibited lower returns (Figure 1). ETFs have matched the returns, but with higher volatility. The risk/return trade-off can be measured by the Sharpe ratio, where higher numbers show more return per unit of risk.

While the average actively managed core mutual fund has a similar risk/reward profile as the index, lower-fee actively managed core mutual funds have historically outperformed the benchmark while only modestly increasing risk, on average. Their Sharpe ratios are generally much higher than those of the average index fund.

Lower-fee actively managed mutual funds are funds with fees in the bottom half of the universe—which are the lower-cost share classes many investors own today.

Why is it difficult for index funds to keep up?

Fixed income index strategies may often have difficulty matching their benchmarks’ performance due to the complexities of bond indexes. The global fixed income market issued more than 25 times more securities than the global equity markets last year.¹ The most common stock market index, the S&P 500® Index, contains approximately 500 liquid stocks. In contrast, the most widely quoted bond index, the Bloomberg U.S. Aggregate Index, contains a staggering 10,000+ securities.²

It is impossible to buy all of those bonds, so an index manager must use statistical analysis and sampling in an attempt to replicate the characteristics and performance of the benchmark using fewer securities. And the gross return must outperform the benchmark to cover the management fees.

How can active managers add value?

The most commonly used benchmark, the Aggregate Index, suffers from many drawbacks that provide active managers with more opportunities to generate excess returns and manage risk. These shortfalls include limited sector exposure, increasing credit risk due to market value weighting and duration that fluctuates with issuance. Active managers may add value to fixed income portfolios by taking advantage of these limitations. Let’s look at each in turn:

Expanding the investment universe

By their very nature, bond indexes are exclusionary, meaning they limit themselves in terms of the opportunity set. For example, the Aggregate Index contains thousands of holdings with a market value of more than $25 trillion.² But the index has minimal exposure to select securitized sectors, such as asset-backed and commercial mortgage-backed securities and non-agency residential mortgages.

It also essentially excludes non-dollar denominated bonds (non-USD), emerging markets debt, global high yield corporate bonds and senior loans (Figure 2). While not all core funds use these extended sectors, we believe adding them in small amounts may help to improve a fund’s return profile without meaningfully changing its risk level or correlation to the Aggregate Index.

In contrast, active managers have the ability to strategically allocate away from potentially lower yielding government bonds. They can often supplement index-eligible bonds with off-benchmark investments that may offer higher yield, greater diversification and less sensitivity to rate increases (Figure 3).

 

Active managers may also have flexibility to add non-USD bonds to improve return potential and increase diversification, as global interest rates follow different paths. These securities are subject to additional risks, including political risk and exchange rate volatility. Active managers carefully consider these risks when choosing how and if to make non-USD allocations.

Enhancing risk-adjusted returns

In fixed income indexes, securities are weighted by the market value of the outstanding debt, so the most indebted issuers make up more of the index. That means passive investors are, by the nature of the index, investing in issuers that have the most debt. To be sure, some of the world’s most successful institutions (including the U.S. government) carry large debt loads. But passive investing may increase exposure to issuers with higher leverage, declining credit quality or, in the case of the U.S. government, substantial interest rate risk. Active managers, using rigorous credit research processes, can focus on the most compelling opportunities, rather than those companies or governments that issue the most debt.

Managing downside risk is critical. Portfolio returns can be hurt more by a bond not repaying its principal than they are helped by a bond repaying principal plus interest. Using in-depth research, active managers can screen issuers who they believe may not repay their debt, or may experience financial hardship that causes their bonds to decline in price before maturity.

Actively managing interest rate risk

Not only is the typical bond index limited in its sector composition, but the sector weights may also change over time. This makes it important for investors to know what they own, as the risk factors (sector, duration, default and prepayment) are not constant, even for an index strategy.

The U.S. Treasury issued more debt in part to finance growing deficits following the financial crisis and pandemic, and as a result, Treasury exposure in the Aggregate Index increased massively from 25% to 40% from 31 Dec 2008 to 31 Aug 2022.³ Figure 4 shows the current Aggregate Index breakdown.

Major bond market participants can often have primary interests outside of maximizing income and return. Central banks focus on controlling growth and inflation, while financial institutions often manage against book yield or regulatory constraints. These entities make up more than half of the participants in the bond market.

The index’s duration has also increased over time (Figure 5). This increase is due to the higher weighting of Treasuries, along with the increased issuance of long-term corporate debt. Longer duration means the bonds tend to be more sensitive to rising interest rates.

Investors in passive fixed income strategies are, in essence, forced to accept these risks. This provides another opportunity for active managers to add value since they can reduce portfolio sensitivity to changing interest rates in two ways:

1) Manage overall portfolio duration. As rates rise, a portfolio with a shorter duration will generally experience a smaller price decline than one with a longer duration. Portfolio managers can actively lengthen or shorten duration as rates rise and fall throughout the cycle. By their nature, passive strategies can’t do this, and it would be extremely difficult for an individual investor to attempt this by purchasing single bonds.

2) Position portfolios along the yield curve. Interest rates do not typically rise uniformly along the yield curve. For example, if long-term rates rise more, the yield curve steepens. In this environment, an active manager has the flexibility to emphasize intermediate-term securities. This flexible approach avoids or de-emphasizes the long end of the curve where interest rates can have a greater impact on bond prices.

Active fixed income management offers opportunity

While indexing and ETF investing has increased in popularity over the past few years, we believe actively managed fixed income strategies will continue to add value.

Actively managed portfolios have provided better returns with less risk than passive portfolios. Active managers can adjust their sector allocation, benefit from bottom-up security selection and position portfolios to minimize the impact from rising rates.

Together, these levers make active fixed income an attractive management strategy.

Before investing, carefully consider fund investment objectives, risks, charges and expenses. For this and other information that should be read carefully, please request a prospectus or summary prospectus from your financial professional or Nuveen at 888.849.5734 or visit nuveen.com.