Fixed Income

Passive Bond Strategies: A Road to Nowhere

By Douglas J. Peebles May 09, 2017
Passive Bond Strategies: A Road to Nowhere

Driverless cars may be the wave of the future. But when it comes to bond investing, it’s best to keep your hands on the wheel. Anything less could do serious damage to your fixed-income portfolio.

It can be tempting to opt for a passive approach in fixed income. Passive strategies are the driverless cars of the asset-management world—they bring investors to the market, then let them sit back and enjoy the ride. But the ride may be bumpier than many realize. In fact, pressing the autopilot button today could make you a sitting duck in the face of rising interest-rate and credit risk.

CHEAPER AND SAFER? THINK AGAIN

When we ask investors what they like about passive strategies, they often zero in on two perceived benefits: they’re cheaper and less risky than active ones. Here’s the problem: in fixed income, that isn’t necessarily so.

To see what we mean, consider your high-income allocation—the part of an overall bond portfolio that focuses on return-seeking assets such as high-yield bonds or emerging-market debt. Investors, of course, buy these credit assets to boost income and returns.

But going passive often means accepting lower returns. Take high-yield bonds. Over the long run, passive high-yield exchange-traded funds have consistently underperformed active mutual funds—in both Europe and the US.

Why? Partly because tracking a high-yield index is hard work. Bonds enter and exit the index often, and ETF managers must trade frequently to keep up. This raises management costs and cuts into returns. And it helps explain why some of the most popular high-yield ETFs aren’t that much cheaper than active mutual funds.

MAINTAINING ROOM TO MANEUVER

Hitching your portfolio to an index also limits flexibility—particularly when credit looks expensive. In the US, high-yield credit spreads—the extra yield high-yield bonds pay over comparable government debt—are near multiyear lows today, and the credit cycle is well into its ninth year.

At this stage of the cycle, rising interest rates can lead to more defaults by low-quality borrowers. With careful credit analysis, active managers stand a better chance of avoiding at-risk bonds.

BOND INDICES’ NOT-SO-HIDDEN RISKS

There’s another problem with bond indices: Most are issuance-weighted, so countries and companies that borrow often are the index’s biggest constituents. For example, investors who use a passive global bond strategy would have hefty exposure to Japan because it issues a lot of debt.

But many Japanese government bonds today carry negative yields. That means passive investors are paying Japan for the privilege of lending its government money—and reducing their portfolios’ return potential in the process.

They’re also exposing themselves to considerable downside risk when interest rates begin to rise. That’s a risk that extends well beyond Japanese bonds. After all, Japan’s government was far from the only borrower in recent years scurrying to lock in low rates and extend maturities.

Consider that a decade ago, the Bloomberg Barclays US Aggregate Bond Index had an average duration—a measure of interest-rate risk—of 4.5 years and an average yield of 5.3%. By the time 2017 rolled around, average duration had climbed to 5.9 years, while average yield had plunged to 2.6%.

Globally, it’s a similar story. Over the past three years, the average duration for one of the biggest international bond ETFs climbed from 6.8 years to 7.9 years.

This may be more interest-rate risk than investors want when the US Federal Reserve is in rate-hiking mode and may soon begin shrinking its $4.5 trillion balance sheet. If the Bank of Japan and the European Central Bank eventually follow suit, yields could rise sharply, exposing benchmark investors to big losses.

WITH BONDS, HANDS-ON IS BETTER

Active managers who go beyond the benchmark can zero in on securities likely to do well while avoiding those whose risk doesn’t seem to justify the potential rewards. They can reduce credit risk by shifting their focus to regions and sectors that are at earlier stages of the credit cycle (emerging markets, European high yield) and reduce interest-rate risk by focusing on shorter-duration securities.

More importantly, among the most effective active strategies are those that combine government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single portfolio and let managers adjust the balance as conditions change.

This approach can help managers get a handle on the interaction between interest-rate and credit cycles and make better decisions about which way to lean at a given moment.

This type of integrated approach isn’t possible if you’ve tethered your portfolio to an index. That’s why, when it comes to bonds, an active approach is the less risky one.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Passive Bond Strategies: A Road to Nowhere
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