The dominance of passive investing in the equity sphere has “polluted bond markets”, according to Damien Hill, manager of the BNY Mellon Responsible Horizons UK Corporate Bond fund, who said investors “should always go active in fixed income”.
His assertion is seemingly backed up by the data. Around 70% of the IA Sterling Corporate Bond sector have beaten the ICE BofA Sterling Non Gilts index over the past one, three and five years, although this drops to less than half (47%) over the decade.
Yet passives are popular. The two largest funds in the IA Sterling Corporate Bond sector are both trackers: the Vanguard UK Investment Grade Bond Index and the iShares Corporate Bond index.
Over the past one, three, five and 10 years, both strategies have underperformed the average fund in the IA Sterling Corporate Bond sector. Hill explained this is because the fixed income market is “incredibly inefficient”, allowing active managers to differentiate themselves.
Most of the market is dominated by more credit-sensitive investors, such as pension funds, who often allocate passively, forcing them into the same companies’ debt.
This leaves the door open for active managers to look for opportunities in less indebted businesses, particularly those further down the rating spectrum in lower-quality investment-grade or better-quality high-yield bonds, which can pay investors more for the risk they are taking.
Additionally, only about 50% of the UK corporate bond market is composed of domestic companies, so more adventurous active managers can often access higher-yielding, regionally diversified companies that a passive fund might miss.
Bryn Jones, manager of the Rathbone Ethical Bond Fund, concurred. “The idea that passive always outperforms in fixed income is a total lie,” he said.
The companies with the highest market share in the index are not the highest quality but the “most indebted companies”. This forces passives to buy more companies that have unsustainable levels of debt, which can lead to default.
As an example, he pointed towards Thames Water and other water companies, which made up almost 6% of the UK corporate bond index earlier this year.
Passives have been forced to hold a similar percentage, but the position looks untenable with Thames Water on the verge of bankruptcy. There were hopes that an approach from private equity firm KKR could save the day, but it withdrew its emergency bid, leaving the future of the company in doubt.
Passive bond funds can hold companies on the edge of default, he said, and are “often too late to access exciting opportunities”. This is because “when yields get low, the duration of the index tends to rise,” even though investors should have a shorter duration during periods of low yields.
When yields were at all-time lows in 2020, the index had an all-time high duration of nine years. Passives then “got destroyed” in 2022 when interest rates rallied.
By contrast, active managers are more flexible, picking less risky bonds with a lower likelihood of default, adjusting duration or adding to mispriced assets in periods of high volatility.
This is crucial because a bond fund is about margins, according to Jones. Bond funds should focus on “achieving marginal gains and avoiding marginal losses”, which is much more challenging in a passive fund. “As a part of a long-term strategy, I just don’t see why you should ever invest passively in fixed income”, he concluded.