Passive investing has become increasingly popular for fee-sensitive investors. And for large-cap equity strategies, that sensitivity has historically proved wise. These indices beat the stock-pickers over time, but the problem is painting passive, low-cost indexing with a broad brush. While U.S. large cap equity markets are seen as the most efficient, managing the structurally-unique fixed-income markets with the same touch comes with inherent risks.
How equity and fixed-income markets are different
Unlike their equity counterpart, bond indices rebalance monthly, which requires both active and passive investors to trade because bonds constantly mature and new bonds are issued. Index inclusion and exclusion rules are also creating movement in and out of indices, increasing the average turnover rate. While the S&P 500 turns over roughly four percent of its securities per year, the bond standard bearer, the Barclays Aggregate, experiences a 40 percent turnover rate.1 And to illustrate this point, from February 2016 to February 2017, the iShares Core U.S. Aggregate Bond ETF saw a 242 percent turnover rate!2 It bares emphasizing that your exposure in fixed-income, low-cost indexing generally looks far different than what you bought into. In reality, it’s not really that “passive.”
Fixed-income and equity indices also differ on market cap weighting. Equity indices are market cap weighted with the most historically successful companies becoming a larger piece of the pie. In fixed income, however, the most heavily weighted entities are those with the most debt, leaving investors significantly exposed to debt-laden, less creditworthy issuers. As an example, Apple (AAPL) has had a solid credit rating for years, but it only issued its first bond in 2013. AAPL couldn’t have been included in investment-grade bond funds before then.
Equity and debt issuers can also look different. While equity securities are issued by corporations, bonds or loans can also be issued by municipalities and sovereign governments, which have simply stopped paying their notes at times, leaving the debt-holders with limited recourse.
Finally, unlike the equity market, passive fixed-income strategies exclude more than half of the total bond and loan universe – a roughly $21 trillion missed opportunity of non-indexed securities.3 Sectors not included or underrepresented in the Barclays Aggregate include commercial mortgage backed securities, collateralized loan obligations, and floating-rate loans, all assets with attractive yields and limited interest rate risk. Instead, after a decade of deficit financing, nearly 70 percent of the Barclays Aggregate comprises low-yielding, high-duration, government-related securities.3
The risks embedded in passive fixed-income indexing
Passive exposure to bond and loan markets may pressure your portfolio when the business cycle turns. As traditional indices reflect less attractive – and potentially more susceptible – risk-return profiles in the years to come, there are several risks to keep in mind.
Though the Federal Reserve is currently on an abrupt interest rate freeze, that doesn’t mean rising rates are a dynamic of the past. And that spells trouble for the Barclays Aggregate, which has taken on greater rate risk since the Great Recession. Duration, which measures the sensitivity of a bond’s principal to rate changes, increased by 62 percent from 2008-2016. Bond math shows that a one percent increase in the yield curve would cause a roughly 2.5 percent greater decline in bond values in 2016 compared to the same rate move in 2008.
The higher duration makes sense when you consider that debt issuers, corporations, and municipalities have issued more long-dated debt in today’s low-rate environment. This influx of longer maturities into the market has pushed up the duration of a passively-indexed bond fund. And remember, the Barclays Aggregate does not include some of the alternative credit products that may limit rate risk in this environment. Instead, it’s been pulling more rate risk into a portfolio as rates now sit higher.
Credit risk also impacts indexed bond funds as fears loom of potential downgrades of investment-grade bonds to high yield as the cycle ends, especially for the BBB- portion of the syndicate. Triple-B (BBB) bonds have $3.1 trillion market cup and make up nearly half of the investment-grade corporate bond universe.4
Credit Suisse estimates $95 billion of BBB- rated issues have a negative outlook or are on the watch list of at least one rating agency. Some of the most levered bonds are those relying on continued merger-and-acquisition synergies to maintain their investment-grade rating – not where to hang your hat if an economic slowdown pressures cash flows.
We started to see this dynamic play out in 2018 as downgrades doubled upgrades despite strong economic growth, according to J.P. Morgan. Now, as global growth moderates, those fears are even more real. Passive strategies with investment-grade mandates would become forced sellers if more of their bonds become fallen angels, pressuring investment values.
Despite these increasing risks, investment-grade passive indexing is offering less income than a decade ago. In all, passive fixed-income investing is more sensitive to rates, is exposed to greater credit risk, and is delivering less income.
Why actively managed fixed income makes sense
Instead of eating into investment returns, we believe active management fees may be providing greater value. An active presence in new bond issuance may find mispricing or valuation issues to help capture the greatest returns, while security-level credit research can span the entire credit universe, not missing out on the income potential of non-indexed securities. Active managers can also shift more quickly to a dynamic macroeconomic environment, helping navigate Fed policy changes and end-of-cycle credit risks.