Artemis: Why active might be better than passive for corporate bonds

Passive investing continues to gain in popularity in bonds as well as equities. The amount of assets held in exchange-traded bond funds went through $1trn last year1, a near five-fold increase since the global financial crisis. Passive funds now have over 25 per cent of the market for bond funds2. This shift has been driven by a desire for low-cost exposure to fixed-income markets.

Passive investing is obviously popular, but is it the best approach for bond investors? Here are a few of our observations.

Credit index weightings are based on the amount of debt a company has outstanding. The result is that more indebted companies have higher weights in the index than less indebted companies. So if a company makes the decision to borrow more, its weighting goes up accordingly.

But why should a company’s decision on raising capital drive an investor’s decision to hold its bonds? We don’t think it makes sense to build a portfolio on this basis. When putting together our portfolios we look to allocate capital to companies with low and declining debt, rather than high and rising debt.

Unlike equity indices, where holdings can stay the same for many years, and rebalancing changes are generally slow and gradual, fixed income indices are subject to constant change. Index rebalancing takes place monthly in order to reflect the changes from bond issuance, redemptions, ageing (as bonds shift between maturity buckets) or changes to ratings (as bonds shift between investment-grade and high-yield).

 

These rapid index changes mean that indexed credit funds have to be highly active in order to keep up with changes in the underlying market. So, if all investors in credit are active to some extent, it seems to us that the question is what type of active investor you would like to be? One trying to replicate an index, or one picking a small number of high-conviction bonds?

Equity indices have a relatively small and fixed number of constituents, which makes them fairly easy to track. But because of the constant changes outlined above, credit indices contain thousands of securities. For example, the ICE BofAML Global High Yield index currently contains 3,113 securities. Because of this, credit index funds take a sampling approach – that is, they select a small subset of securities designed to provide a rough match with the broad risk characteristics of the index itself. So, when you invest in a credit index fund, you’re not investing in the index itself, but rather the index manager’s own interpretation of that index. This means that credit index funds can have significant tracking error. They also have a history of materially underperforming the indices they are meant to track.

In fixed income, there is no significant cost saving available by taking the indexed fund approach. Credit index funds are priced at similar levels to active funds. There are also hidden costs, given that investors are likely to buy index funds at a premium to net asset value (NAV) when the market is going up, and sell at a discount to NAV when the market is going down. The rapid turnover in credit indices also means that trading costs are high.

For instance, active managers can hold more or less duration than the index. This is important because the duration of an index, being based on maturities required by corporate borrowers, is not necessarily optimal for a particular investor. They can take ‘off-benchmark’ positions in other areas of the bond market if they think it is appropriate. They can reduce interest-rate risk in a rising rate environment; or credit risk if they expect credit to deteriorate, such as late in an economic cycle. Passive investors, meanwhile, are more exposed to unfavourable changes in a borrower’s creditworthiness than active investors, who can simply sell the bond.

 

By way of example, our strategy is designed to enable the managers to invest in only the most suitable securities, regardless of their weight in a particular index. The fund will usually hold 75-150 securities, compared to over 3,000 in the global high yield bond market. This allows us to be highly selective in our approach.

The ‘mechanical’ investment rules of passive investing give rise to distortions in the pricing of individual securities. Active investors (not hidebound by rules) can exploit these pricing anomalies and potentially outperform.