How active can help fixed income investors amid uncertainty

Passively managed funds are considered to be more cost-effective in terms of fees, while active managers are said to offer valuable expertise, which is why they can charge a fraction more. 

But for bond investors the debate becomes more shaded: some claim the bond market is so large and so liquid that it is much more difficult to find the market inefficiencies that are supposed to enable an active manager to add value. 

Increased volatility and dispersion only increases the opportunity set for active investors.Grace Le, Artemis

Conversely, passively managed bond funds are often heavily skewed towards the most indebted companies in terms of portfolio weighting, potentially ramping up the risks for investors.

Then there is the question of why investors may be holding large bond allocations: if they want income, do they want to pay a manager to deliver that little bit extra? 

Protection 

For Grace Le, who co-manages the £718mn Artemis Corporate Bond Fund, much of the job of an active bond fund manager is to protect client portfolios in the sort of uncertain economic times in which we find ourselves.

Le comments: "Markets are inefficient and are pricing in different scenarios.

For example, markets are currently pricing RPI to peak at 14 per cent in the UK and for the Bank of England to raise interest rates to 2.6 per cent by the end of the year, which would usually imply a strong macroeconomic backdrop.

"However, parts of the market such as long-dated bonds have yields near their historical lows, reflecting concerns around growth."

Active management can provide with incremental returns over passive strategies.Fahad Kamal, Kleinwort Hambros

Because credit spreads (how much more investors are compensated to be invested in corporates compared with governments) are near their historic wides, the market is presently pricing in a negative economic scenario. 

Le says with the reversal of quantitative easing, which she describes as "a tide that has lifted all boats for the last decade" there will be much greater volatility in bond markets.

She calls this: "A boon for active investors. We see bond markets behaving irrationally frequently, and increased volatility and dispersion only increases the opportunity set for active investors."

Muzinich & Co's co-head of public markets Michael McEachern, agrees. He says: "Bond investors must contend with inflation, the potential for recession and global macro uncertainties.

"In the current environment, active bond managers can take steps to protect client portfolios by: rotating into higher-quality credits that are less sensitive to current challenges; investing in shorter-duration bonds and loans that are less impacted by increasing rates."

He adds: "Credit has an asymmetric risk-profile – that is either a company defaults or it pays par at maturity. Strong fundamental analysis is essential to avoid investing in companies that default."

Avoiding concentration risk

Earlier in 2022, FTAdviser interviewed Artemis fixed income manager Stephen Baines, who acknowledged the rising popularity of passive bond strategies.

There have been significant inflows of money in recent years into passive funds such as exchange-traded funds that track bond indices, as investors have sought ways to get exposure to credit without paying active fees or as a way to play the market through higher-frequency trading. 

But Baines explained these strategies can work against the investor, causing them to end up with a fund that has a high concentration of risk, higher trading costs and a significant deviation from the performance of the underlying bond index.

Portfolio construction means passive funds do not track all the bonds within a given market. For example, while there are more than 2,000 bonds in the US high-yield bond market, the largest ETF holds just 1,321. The sampling error by which companies are chosen to be in that passive fund, the ETF or tracker, is automatically skewed towards the most indebted issuers, which could pose enormous risks.

Income generation

According to Kleinwort Hambros' chief investment officer Fahad Kamal, active management also helps to boost income. 

He says: "Income (coupons) is of paramount importance, especially in an environment of low and stable yields. Bond returns were boosted by a secular wave of multi-decade, ever-lower yields that probably came to an end in 2020.

"In a highly volatile rates environment, active management can provide incremental returns over passive strategies, for example by adjusting duration, yield curve positioning, sector and issuer selection."

Exploiting carry trades

Fund managers can occasionally deploy carry trades to make a return for investors.

Carry trades involve borrowing at a low interest rate and investing in an asset that provides a higher rate of return.

For example, a manager might want to benefit from currency movements, so would borrow a low-interest rate currency and convert the borrowed amount into another currency by buying the bonds of that country.

McEachern explains: "For short-dated bonds, carry (which represents the interest income in excess of the risk-free rate) is a source of return.

"In a yield rising environment, investors can take advantage of higher-yielding assets as existing holdings mature and new issuances are released at higher yields."

He adds: "Carry helps to offset bond prices fall. As prices have dropped the carry has risen and is now much higher than it was at the start of the year. "

Investors should ask what are the implications of this? McEarchern continues: "Looking exclusively at the carry element, if we were to see similar interest rate rises and spread widening as seen over the past five months, this will more likely result in the bonds not incurring losses.

"The first half of this year has been particularly painful, because we started with low carry, a negative yielding market, and no protection, followed by a sharp price decline.

"Now, the carry is helping to offset the price declines. If there were future price declines, the carry would go higher and help to offset the price movements."

This is central to the principle that when bond prices rise, the yield falls, and vice versa. 

For Fairview Investing's co-founder Gavin Haynes, to do these kind of trades, one needs to use an active manager. 

He says: "If carry is one's motive for bond investing, this is best achieved via active management in bond markets using strategic bond funds; absolute return bonds and select global bond funds provide the best options.

"Fund managers can use tools to exploit interest rate, credit and currency movements", he explains.