Why passive investing doesn't always work in fixed income
Passive investing thrives in efficient markets, but fixed income faces more headwinds
Simply buying and holding an index fund is a common sense approach to investing, but it doesn’t always work for fixed income. The bond market functions quite differently from the stock market, and those differences can hold back passive bond funds.
Morningstar’s US Active/Passive Barometer recently found that active bonds funds tend to have much higher long-term success rates than stock funds.
Stock indexes reward success, bond indexes reward borrowing
Constructing a bond index is less straightforward than a stock market index. More specifically, market capitalisations guide the weighting of stocks in most prominent broad market stock indexes. Replicating the index is easy because weights float with performance and require minimal rebalancing. When a broad market fund needs to buy or sell stocks, they are typically easy and low cost to trade.
With bond indexes, weighting methods vary considerably. But most prominent indexes weight bonds by market value. While conceptually similar to market-cap weighting in stock indexes, the two methods produce very different results.
Market-cap-weighted stock indexes place the most weight on the companies that the market believes are the most valuable. Market-value weighting bonds, on the other hand, emphasises companies or institutions with the most debt. Companies that issue the most debt aren’t necessarily the most successful, but they may be the most levered.
The bond market is harder to index
Passive bond investors face other challenges that don’t exist in the stock market. Stocks trade on centralised exchanges and can be easily bought or sold, while most bonds trade infrequently through over-the-counter systems that match buyers and sellers. Modern day electronic systems have improved the speed and accuracy of bond pricing by allowing traders to communicate faster and more effectively, but bond trading remains far less automated than stocks. Complex bond orders often still require direct chats or phone calls.
Another challenge unique to bonds is that a small number of large investors can hold most of an issue, making it more difficult to find willing buyers or sellers. Without a centralised exchange, simply locating and pricing bonds can be a challenge. Morningstar’s 2021 study of 350,000 bonds found that 57% were held by only one asset manager and just 23% were held by more than three. This concentrated ownership makes it nearly impossible for bond ETFs to fully replicate broad indexes.
Active and passive bond funds take different risks
Passive bond funds tend to have different risk profiles than their active peers, more so than in equities. Equity index funds tend to have sector allocations that hew closely to their average peers.
Passive bond funds that aim to capture a wide market, such as the funds in the table below, tend to hold significantly more of their portfolio in government bonds, such as treasuries. That means they carry distinctly more conservative portfolios, in terms of credit risk. While dialing back credit risk might be a good thing, that’s not always the case.
Passive fixed income funds can be overly conservative, leaving yield on the table. Yield is the primary engine of the fund’s total returns, and there’s a few ways to get it. The first is to increase credit risk. Bonds that are backed by the US Government, like treasuries, come with very little credit risk, and consequently lower yields. Riskier bonds, like high-yield corporate bonds, offer greater income, with their higher yields reflecting the lower likelihood of repayment.
A strong credit research team can exploit inefficiencies in the bond market by identifying securities whose yields overstate their true credit risk. In other words, active managers may be able to earn additional income without taking on an equivalent increase in risk. When successful, this allows them to improve a portfolio’s yield while adding less risk than a bond rating or market pricing might suggest.
Passive funds lack such flexibility, and market-value weighting can steer their portfolios into conservative offerings. Many popular broad market bond indexes tend to allocate copious amounts of their portfolios to government securities offering lower yields, because of their prevalence in the bond market. That’s great during a credit shock, like at the beginning of 2020, but over time that yield disadvantage tends to steadily drag on returns.
The second lever a portfolio manager can pull to increase yield is to buy longer-dated bonds. Longer-term bonds tend to carry higher yields, as compensation for locking up capital for a longer period. The exception to that rule can happen when investors expect the economy to slow down. In anticipation of rate-cutting to stimulate economic growth, investors will rush into long-term bonds to lock in higher yields, thus driving up the price of those bonds and reducing their yields.
Adding longer-term bonds to enhance yield isn’t always plausible when a bond fund has a specific term mandate. Also, adding longer-dated bonds increases a funds duration: a measure of how much it should fluctuate when rates rise and fall. And longer durations lead to greater price swings.
Where active thrives, and where passive makes a case
As a rule of thumb, passive investing works better in markets that are easy to access and trade. That allows a wide range of investors to voice their opinions through their buying and selling. That tends to be true of the bond market as well.
For example, passive investing works well in the US Treasury and TIPS markets because hundreds of billions of dollars of Treasuries change hands every day. But other segments of the bond market are smaller, the bonds trade less often, and they’re dispersed across a narrow range of investors. Index-tracking ETFs are less effective in such segments, which lends them better to active managers who can take advantage of those inefficiencies to carve out an edge.
