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Takeaways from an unforgettable year in bonds

Tim Wong, CFA  |  19 Apr 2021Text size  Decrease  Increase  |  
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The diverging fortunes of active and passive bond managers in 2020 was among the litany of talking points from an unforgettable year. By the market's nadir in March, several index trackers stood near the top of the leaderboards, with many active competitors stung by the rapid declines in valuations for credit as liquidity vanished. This didn't last long, however, as vast policy support rekindled the appetite for risky assets, enabling a parade of active strategies to finish well ahead of market indexes when measured over the full year. What can investors learn from this remarkable period, particularly when it comes to constructing their fixed interest allocations?

Key takeaways

  • The tendency for many active managers to hold a greater weight in non-government-related bonds than typical market benchmarks explains much of the difference in how these cohorts fared in 2020. This is not a new phenomenon.
  • The bulk of active managers ended up outperforming their respective indexes over the full course of 2020. This is both a laudable feat and yet not immune to criticism—this return profile (relative to index) broadly follows the experience of equities, raising questions about their expected diversification benefits in a broader multi-asset portfolio. Indeed, active fixed interest strategies have commonly struggled when credit spreads have widened.
  • Investors should still remember the reasons for why credit is held to begin with. It’s a source of income that can bolster performance above indexes, and active managers can capitalise on significant mispricing as in 2020. Even after accounting for occasions when credit spreads widen, this segment operates without much fuss for lengthy spells, reflecting the typical business cycle.
  • The sizable government-related bond exposure and lengthy duration of many passive vehicles can be susceptible to rising and steepening yield curves. Higher bond yields may increase the cost of capital for risky assets, and so the potential for bonds and equities to fall in unison becomes the real danger when constructing multi-asset portfolios.
  • Again, we think it’s best to be alert to this risk, rather than rush to pass judgment. There are many potential outcomes, and events don’t unfold in a vacuum. Warding off higher yields is a valid concern, and there are plenty of lower duration strategies, particularly across the more flexible bond cohort, that can assist—just remember most assume some form of credit risk rather than interest rate risk. From our standpoint, constructing a bond allocation that can handle a diverse range of situations is why we remain amenable to both passive and active capabilities across both the index-relative and index-agnostic realms.

2020: A year of contrasts

The abrupt change in fortunes between passive and active fixed interest strategies during 2020 was eye-catching. Passive bond strategies fared reasonably well during the dramatic collapse in markets during the onset of the pandemic, as we noted in our article Corona sell-off: Best and worst fixed-income funds published in March 2020. This was evident across two fixed interest bedrocks—Australian bonds and global bonds. As we noted at the time, much of this discrepancy stemmed from the large structural allocation to government-related bonds in many passively-managed capabilities. By contrast, many (but not all) of the active cohort run with above-index exposure to credit and other spread sectors, which suffered as markets shunned risk and prioritised liquidity. It wasn’t all plain sailing for passive strategies, with iShares Core Global Corporate Bond (ASX:IHCB) stumbling heavily, though this is still symptomatic of main issue, namely portfolios taking on more credit risk generally fell harder. The following snapshot of performance from the start of the year to 23 March 2020 in Exhibit 1 shows just how prominent passive strategies from Vanguard and iShares were among our qualitatively-rated universe, and how the weight in credit often played a major role. (We’ve excluded securitised bonds for this purpose even though many could be classed as spread-based assets, given issuance by government-sponsored entities, especially globally.)

Exhibit 1: Performance summary from start of 2020 to the pandemic drawdown

Exhibit 1 Performance summary from start of 2020 to the pandemic drawdown

Source: Morningstar Direct. Data as of 8/4/2021

Around this time, we had also found that taking big swings in actively managing duration hadn’t really proved beneficial, at least in terms of outright performance (see the article “Playing Hero Ball in Bonds: Does it Pay to Stick Your Neck Out?” May 2020). Combined with how the pandemic was unfolding, it was natural to wonder whether passive strategies were attaining the upper hand relative to the active cohort. We didn’t think this was warranted. The unique circumstances of the pandemic and indeed the structural decline in interest rates since 2008 cannot be understated, and a blunt view of performance relativities ignores how active managers may be balancing out different risks (for example, handling the greater sensitivity to capital declines if interest rates unexpectedly rose) that may be in keeping with investor expectations.

From 24 March onwards, most active managers fared far better than passive options in Australian and global bonds. Dwindling risk aversion saw credit spreads compress dramatically. Several active managers also amped up exposure to credit during the second quarter of 2020 to capitalise on the valuations on offer and issuance that followed. This included (but was not limited to) the likes of Janus Henderson Australian Fixed Interest (5666), AMP Capital Australian Bond (16869), Schroder Fixed Income (10862), and Legg Mason Brandywine Global Opportunistic Fixed Income (16192). Exhibit 2 this time shows results from 24 March to the end of the year, alongside the average exposure to corporate bonds.

Exhibit 2: Performance summary from March rebound to the end of 2020

Exhibit 2: Performance summary from March rebound to the end of 2020

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Source: Morningstar Direct. Data as of 8/4/2021

React? Stand pat? Making sense of what happened

What should we make of this all this? Obviously, care is needed in assessing events over short periods—especially amid such extreme market movements. The bulk of active bond managers ended up outperforming their respective indexes over the full course of 2020. This is commendable. At the same time, this feat isn’t immune to criticism. Namely, many active fixed interest strategies struggled when investors were clamouring for a source of portfolio defence and liquidity. It took enormous support by policy makers and central banks for bond markets to resume functioning more normally, setting the stage for many active managers to outperform alongside the eye-popping rebound witnessed in equity markets.

This procyclical spell of returns in 2020 raises the topic of portfolio fit and finding diversification for investors and their advisers. If we look back further, wider credit spreads are a common factor when active managers have lagged indexes in bulk. This occurred in 2008, 2011, 2015, and 2018 among the Australian bond cohort (Exhibit 3 shows the active returns against the benchmark). It’s a similar experience in global bonds (not shown), though the sample is considerably smaller.

Exhibit 3: Active returns for qualitatively-rated Australian bond strategies, 2005–20

Exhibit 3: Active returns for qualitatively-rated Australian bond strategies, 2005–20

Source: Morningstar Direct. Data as of 8/4/2021

These observations are interesting, but not greatly troubling. As modest active duration positions are the norm rather than the exception in many Australian bond portfolios, fluctuating credit spreads are often a swing factor dictating relative performance. Credit is also held for a reason—it’s a source of income that can bolster performance above market indexes—and instances of significant mispricing can prove beneficial for managers with the savvy and wherewithal to capitalise. It’s also necessary to distinguish between the rare occasions of major liquidity stress, as witnessed in early 2020 and 2008/09, from the regular ebb and flow of market risk appetite. Even after accounting for occasions of widening credit spreads, this segment operates without much fuss most of the time, reflecting the typical business cycle.

Volatility: Friend or foe?

Exhibit 3 also showed noticeably more disparate fund returns in 2020, at least compared with much of the preceding five years. Active managers also surpassed the index en masse in 2009, 2010, and 2012, years with a broader range of returns. It’s natural to wonder whether renewed bond market volatility affects the respective merits of active and passive strategies.

The defining trait of many passive vehicles is their sizable government-related bond exposure and lengthy duration. We are under no illusions about the pain rising and steepening yield curves can wreak on this stance. Higher bond yields may also have more pervasive impacts elsewhere, namely increasing the cost of capital for risky assets, an intimidating prospect given the low starting point of yields. Bonds and equities falling in unison then becomes the real danger. Before rushing to hit the sell button, consider that there may be a range of consequences on portfolios, some more pressing and others distant. After absorbing the initial valuation hit, a steeper yield curve restores some of the value of longer duration bonds as an insurance policy against another unexpected risk off event. Equities may be unaffected unequally—heavily-leveraged businesses with weaker cash flow generation, or those viewed as low growth yield proxies could be more susceptible to markedly higher funding costs. This may spill over into credit markets too, though default probabilities and liquidity should be the main determinants of spreads over time.

Events don’t unfold in a vacuum though. Active managers aren’t guaranteed to outperform indexes, though volatility affords more scope to succeed. If warding off higher yields is the primary concern there are plenty of lower duration strategies, particularly across the more flexible bond cohort, that may play a role. Just remember that the bulk are trading off interest rate risk for some form of credit risk. Weighing the prospect of higher rates is prudent, just remain aware that it’s one possibility among several. Incorporating this within a total return mentality that emphasises diverse outcomes to the remainder of your portfolio is entirely feasible—that’s why we remain amenable to both passive and active fixed interest strategies, across both the index-relative and agnostic realms.

is director, fixed income strategies, at Morningstar Australia.

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