Ellen Carr writing in the FT lists four reason why bonds should be actively managed.
First, true indexation — that is, investing in all the securities in an index — is impossible in fixed income. It’s not just that the Agg contains more than 12,000 bond issues. It is also the challenges of trading corporate bonds privately between counterparties, or “over the counter”. The average corporate bond trades infrequently a month after issuance, resulting in potentially large spreads between bids and offers, a cost that the indices don’t incur. With that backdrop, it’s remarkable that the two largest passive vehicles have managed to generate (albeit lacklustre) results in line with the Agg.
Second, by definition, the index overweights issuers with the most debt — which suggests a bias towards lower-quality companies. Take two examples in the same industry, Oracle (rated Baa2/BBB+ by Moody’s and S&P, respectively) and Microsoft (a AAA-rated “unicorn”). Since Oracle is a larger component of the index than Microsoft, a passive strategy must own more of the former, while active managers might choose to avoid it given its negative credit rating trajectory.
The index has also experienced an increase in BBBs, the lowest rating rung of the investment-grade corporate universe, over the past decade. Passive strategies have no choice but to follow the ratings trajectory downwards.
Third, a meaningful component of alpha in investment grade comes from asset allocation decisions among the three primary sectors of the index — Treasury bonds, mortgage-backed securities and corporate bonds.
A common criticism of active fixed-income investing is that managers blindly overweight higher-yielding, riskier MBS and corporates to juice returns (and subsequently blow up when risk appetite declines sharply). But the reality is more nuanced. According to JPMorgan data, the level of average risk-adjusted returns — the Sharpe ratio — in MBS and corporates is higher than in Treasuries, over virtually all time periods. Most active managers overweight these sectors accordingly — a decision not available to passive strategies.
A fourth reason is that in periods of dislocation, fixed-income index funds can be whipsawed by outflows, whereas SMAs are by and large static pools of capital. While an institution might redeploy cash from bonds to stocks in a downturn, institutional behaviour tends to be less herd-like than retail.