Avoiding hidden risks and finding opportunities when selecting a fixed income strategy
When choosing a fixed income strategy, it is critical for investors to understand the fundamentals of bond benchmark and passive fund construction, and the subsequent impact they can have on long-term results. In this paper, we first explain some key aspects of bond indices and how they compare to equity indices. We then elaborate on crucial areas in which benchmarks and passive strategies may leave investors exposed to unanticipated risks, including the reliance on large bond issues, overexposure to heavily indebted companies, and the tendency for benchmark characteristics to diverge over time. We believe the path to mitigating these risks and capitalizing on the opportunities they create is through an actively managed fixed income strategy.
Bond indices exhibit massive scale and differ dramatically from equity indices.
To help understand the scale of bond indices, it is useful to compare them to equity indices, which are remarkably different in characteristics and composition. In Exhibit 1, we show the market value, number of securities and turnover of several leading bond indices relative to three prominent equity indices. Consider the contrast between the Bloomberg Barclays Global Aggregate Bond Index (Global Agg), one of the largest global bond indices, and the MSCI ACWI (ACWI) equity index, one of the largest global equity indices. The Global Agg has nearly $7 trillion of additional market value and more than 8 times the number of securities as compared to the ACWI.
An additional differentiation of bond indices is the high turnover of the underlying securities. While most equity securities are perpetual in nature, and the frequency of movement of securities in and out of major equity indices is relatively low, the composition of bond indices changes frequently due to bonds having maturity dates, call options and other early redemption features. Corporations may issue new bonds at any time, and many issuers tap the debt markets multiple times per year. This leads to dramatically higher turnover in bond indices versus equity indices.
Owning and rebalancing every security in these large bond indices is nearly impossible, so passive strategies typically employ a sampling methodology to replicate the characteristics and performance of the underlying bond indices. This introduces the risk of tracking error, and it also means passive funds must, by necessity, focus on only the most liquid bond issues.
Passive bond funds and ETFs rely almost exclusively on large bond issues, which underperform small bond issues over time.
The sampling methodology (i.e., buying and selling securities) used by passive strategies to replicate the underlying bond indices relies almost exclusively on larger, more liquid bond issues. As shown in Exhibit 2, a prominent investment-grade bond ETF held 99.9% of assets in large issues, leaving only 0.1% invested in small issues. Additionally, most bond benchmarks require a minimum issue size to even be included in the benchmark. This focus on large bond issues means smaller bond issues are largely ignored by passive funds and ETFs.
Investors should instead consider managers with the research prowess and flexibility to invest in smaller, often overlooked bonds. In Exhibit 3, data shows that, over time, smaller issues have outperformed larger bond issues by 35 basis points (bps) with less risk, as defined by standard deviation, and higher yield.
Bond indices are weighted toward the most indebted issuers.
It is important for investors to consider the implications of a seemingly obvious point: bond indices are comprised of the debt securities issued by corporations, municipalities, etc. Thus, whereas market value-weighted equity indices skew toward the largest, most promising issuers (e.g., those with the strongest growth forecasts or the highest expected future cash flows, etc.), bond indices skew toward issuers with the most debt on their balance sheet. And, clearly, corporations with the highest debt balances are most reliant upon a well-functioning market and are exposed to risks that could make repaying or refinancing that debt more difficult, whether due to broad market pressures, increases in interest rates, or deteriorating business/credit fundamentals. Unlike passive strategies, an active bond manager can choose to avoid these heavily indebted issuers and invest instead in issuers with greater financial strength and potential to outperform over time.
Bond benchmark characteristics have shifted over time.
Investors should be aware that bond benchmarks often drift away from what may be the original desired exposure, making them susceptible to unforeseen risks that could negatively impact their long-term results. As shown in Exhibit 4, over the past 20 years, the Bloomberg Barclays U.S. Aggregate Index (U.S. Agg) has increased exposure to credit by 820 bps. It has also increased duration — sensitivity to changes in interest rates — by 2 years, a 36% increase.
Taking a different view of duration of the U.S. Agg over the past decade, Exhibit 5 shows a time series of changes in both duration and yield. Clearly, there has been a material duration extension along with a dramatic shift down in yields.
Shifts in the characteristics of bond indices (such as the U.S. Agg), and the passive strategies that follow them, may leave investors vulnerable if credit conditions deteriorate or if interest rates reverse the downward trend of the past 30 years.
Bottom Line: Bond investors should look beyond the constraints of a bond benchmark to active management.
Given the difficulty of replicating a bond index’s performance and characteristics, and the risks inherent to passive bond strategies, investors should consider working with active bond managers to meet their return objectives while helping to mitigate risk. Active managers are able to take a more rigorous approach to bond investing, with many opting to research and invest in individual securities based on fundamental analysis, which allows them to avoid issuers with the highest intrinsic risks. Certain active and more nimble managers can also make meaningful investments in small bond issues, which have been shown to outperform larger issues over time with less risk.
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