• Products

    A Guide to Hartford Funds

    View Now >

  • Insights

    The Reimagined Human-Centric Investing Podcast

    See What's New >

  • Practice Management

    Applied Insights Team

    Learn More >

  • Resources

    Tax Center

    View Now >

  • About Us

    Be Human-Centric

    Learn More >

Over the past several years, many investors have moved from active to passive fixed-income strategies, believing these markets offer fewer idiosyncratic risks to exploit than equities and are too efficient for active managers to generate alpha.1 Yet passive approaches have frequently underperformed active strategies across many segments of the fixed-income market and may expose investors to several forms of unintended risk. Active fixed-income management not only offers potential for enhanced returns, but can also add value by aligning an investor’s objectives with risks in several key areas—market structure, credit deterioration, dislocations, and divergence—where index-tracking approaches may fall short.2

 

Reason #1: Performance Potential

Advocates of index-replicating fixed-income strategies argue that active managers cannot consistently outperform the Bloomberg US Aggregate Bond Index3 (the “Agg”), net of management fees. Yet active core-plus fixed-income approaches have historically fared well against the Index over most time frames during the past 20 years, even after excluding a “survivorship bias” (FIGURE 1).

 

FIGURE 1

Active Managers Have Often Outperformed the Agg

Past performance is not a guarantee of future results. As of 5/31/22. Indices are unmanaged and not available for direct investment. Annualized total returns of US-based, active core-plus mutual funds, net of fees. Universe has been filtered to: 1) include those funds benchmarked to the Agg and exclude index funds; 2) mitigate survivorship bias, which occurs when the performance results of a group of managers are calculated using only the survivors at the end of the period and excluding those that no longer exist. Survivorship bias can result in the overestimation of historical performance by assuming that only funds currently in existence were available in the past. These results mitigate survivorship bias by including now obsolete funds that were active historically, but have since closed. Sources: Morningstar, Wellington Management.

Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit.

 

Much of active core-plus outperformance vs. the Agg has stemmed from the dramatic narrowing of credit spreads4 since the Global Financial Crisis (GFC). Managers of investment-grade (IG) corporate debt have also benefited from a narrowing credit curve, as they tend to overweight lower-rated issuers, which have typically outperformed higher-quality issuers when spreads tightened.

Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit. Indeed, active managers have many other levers for seeking to generate alpha, such as sector rotation, out-of-benchmark allocations, duration5 positioning, security selection, and (in the case of global strategies) country and currency selection. These noncredit levers may also mitigate drawdowns during credit-adverse environments.

That said, credit overweights have clearly helped boost excess returns delivered by active managers over most periods—the great exception in the past decade being the GFC. Narrowing spreads since then have compensated for active managers’ shortfalls vs. index returns in 2008.

While the median active manager’s performance vs. the index has tended to be positively correlated to credit spreads—outpacing the index when spreads narrowed and lagging when spreads widened—periods of underperformance have often been short-lived and typically outweighed by longer stretches of outperformance.

In high yield, active management has historically not fared as well. Active high-yield managers tend to be defensively positioned vs. the index; perhaps as a result, they’ve trailed the index when spreads remain unchanged or narrow.

 

Reason #2: Market Structure

Fixed-income markets tend to be fragmented, opaque, and prone to experiencing volatile liquidity. However, these features may benefit thoughtful investors by increasing the premia that can be earned through portfolio implementation and active management (FIGURE 2).

Fragmented: Unlike equity markets, there’s no central fixed-income exchange. Instead, securities are still traded over-the-counter. This often requires a trading desk to strategically plan how it will either buy or sell a bond, allowing the implementation aspect of investing to potentially add value. Moreover, issuers may have different bonds in various parts of their capital structure or in varying currencies and maturities. A single corporate or government issuer may have numerous individual bonds, each with different terms and conditions. That can mean the risks and rewards differ as well. A passive exposure does very little to distinguish among those individual bonds.

Non-economic actors: Some key participants in fixed-income markets are looking to achieve objectives other than a rate of return. These include central banks and the US Treasury, along with banks and insurance companies that may be subject to investment constraints imposed by the regulatory framework. Hence, these counterparties are often not trading based on valuations, leaving room for active investors to purchase or sell bonds at opportune times.

Liquidity and balance sheet: Reductions in dealer balance sheets following the GFC have made liquidity more variable across fixed-income markets. Given that there‘s no central fixed-income venue, investors rely on dealers to serve as counterparties for trades and to hold inventories of bonds. The reduced ability of a dealer to intermediate or serve as a place to store inventory means bond prices can be influenced by the non-economic actors, providing the opportunity for an active investor to supply liquidity when traditional intermediaries cannot and to do so more effectively than passive investing.

Implementation: Fixed-income markets provide a number of ways for skilled practitioners to add value through implementation, many of which aren’t replicable in passive terms. Issuer, CUSIP, and maturity are all important facets of a decision. In addition, active investors can decide whether the exposure looks better in cash (funded) format or through derivatives such as futures (unfunded) and can seek to exploit differentials between the two. Similar dynamics exist for currency markets, where lending dollars via the cross-currency basis market may deliver robust risk-adjusted returns. Over time, these and other tactics have often translated into superior results vs. passive exposure.

 

Indices are designed to be market proxies, not investment strategies

The capitalization-weighted indices that passive fixed-income approaches typically seek to track, such as the Agg, are designed to be transparent, objective, and replicable sets of securities that represent opportunity sets and summarize market information. That said, the standard fixed-income market indices—or more precisely, the passive approaches that seek to closely mirror them—have several shortcomings as investment strategies, including:

  • Performance: By definition, generally cannot outperform the indices tracked
  • Duration: Expose investors to substantial interest-rate risk
  • Downgrades: Cost investors return due to mechanical rules on downgrades
  • Dislocations: Cannot take advantage of pricing dislocations or inefficiencies
  • Divergence: Can fail to accurately mirror the target index

We think investors’ circumstances and goals should drive the composition of their portfolios, not an index provider’s efforts to replicate a given market. Any weighting scheme that excludes consideration of a market’s credit quality, duration, volatility, and liquidity exposure is too narrowly based, in our view.

FIGURE 2

The Structure of Fixed-Income Markets Can Work to Investors’ Advantage

Source: Wellington Management

An active portfolio manager can play an important role in anticipating turns in the credit cycle and avoiding downside risk.

 

Reason #3: Credit Deterioration

An important feature of credit is its asymmetric risk profile: The market value of a bond can fall much more than it’s likely to rise. (In other words, credit yield spreads can widen much more than they can narrow.) An active portfolio manager can play an important role in anticipating turns in the credit cycle and avoiding downside risk. In particular, fundamental research can help managers identify deterioration or improvement in a credit before the rating agencies do, and even before the shift is priced in by markets.

A prominent concern among investors is that lower-rated credits now comprise a larger share of the IG credit universe than in the past, while issuer leverage has been rising and interest coverage has been falling (FIGURE 3). However, in a recessionary environment, interest coverage ratios could worsen, particularly for cyclical credits. Deeper analysis of a company’s leverage ratios is essential to understanding whether or not the company’s ability to service its debt is negatively impacted by higher debt levels. At the very least, higher leverage should be a clear warning sign for credit teams to investigate a company’s earnings and free cash flow, its plans for asset sales and dividends, and how committed its senior management is to IG ratings. An experienced portfolio management team that can go beyond the headlines may be able to identify opportunities and risks.

 

FIGURE 3

Investment-Grade Corporate Leverage Has Been Steadily Rising

US IG corporate credit metrics

As of 12/31/21. Net leverage is a measure of how much of a company’s capital is in the form of debt and is used to evaluate the company’s ability to meet its financial obligations. Interest coverage is a measure of a company’s ability to meet its interest payments. Sources: Capital IQ, Wellington Management. 

Index providers’ rules for credit downgrades can also cause passive strategies to trail active ones.

 

Index providers’ rules for credit downgrades can also cause passive strategies to trail active ones. In the Bloomberg US Corporate Investment-Grade Bond Index,6 securities downgraded by at least two of the three main credit-rating agencies (Standard and Poor’s, Moody’s, and Fitch) must exit the Index by the end of the month in which they are downgraded. But deteriorating credits often sell off before they are downgraded as investors anticipate the downgrade. Consequently, the indices are often forced to sell such bonds after they have fallen in price.

 

Reason #4: Dislocations

Lack of liquidity, merger and acquisition (M&A) activity, and market segmentation can cause market dislocations and create opportunities for active managers, as can responses by government policymakers to such dislocations.

  • It’s particularly in credit sectors that post-crisis regulations have made secondary bond markets less liquid. FIGURE 4 below shows that when spreads widen, the liquidity premium between new and older issues widens, and vice versa. As noted earlier, active managers can seek to benefit from this by acting as liquidity providers, purchasing higher-yielding corporates at steep discounts when others wish to sell them.

 

FIGURE 4

Market Liquidity Conditions Create Opportunities for Active Managers

Observed liquidity cost scores and option-adjusted spreads for IG corporates: 2007–3/22

Liquidity cost score (LCS) is an objective, quantitative bond-level liquidity metric. It’s expressed as a percentage of the bond’s price and measures the cost of an immediate, institutional-size, round-trip transaction. Observed LCS are aggregated across the US IG corporate bond universe as proxied by the Bloomberg US Corporate Index. The Bloomberg US Corporate Index is a market-weighted index of IG corporate fixed-rate debt issues with maturities of one year or more. An option-adjusted spread is a measurement tool for evaluating yield differences between similar-maturity fixed-income products with different embedded options. Monthly observations through March 2022. Sources: Bloomberg, Wellington Management.

M&A activity has accelerated in recent years, generating idiosyncratic risk that active managers can seek to exploit.

 
  • M&A activity has accelerated in recent years, generating idiosyncratic risk that active managers can seek to exploit. Some combinations represent strategic transactions from which synergies may accrue, while others may be done to enhance shareholder value. Active managers can assess companies’ deleveraging intentions and commitments to IG ratings. There may be opportunities for investors to profit from M&A, particularly if the announcement triggers indiscriminate spread widening. Conversely, some debt-funded M&A transactions have pushed the IG limit. If active managers are skeptical of management’s commitment to bondholders, they may choose to avoid/underweight the issuer.
  • Finally, active managers can exploit market inefficiencies caused by market segmentation. For example, BB-rated securities can’t be included in mandates that require IG credits. Without a natural buyer, their spreads may be high relative to their credit risk, handing savvy active managers another potential path to outperformance.

 

Although many investors assume that an index fund will closely track its target index, this is not always the case.

 

Reason #5: Divergence

Although many investors assume that an index fund will closely track its target index, this isn’t always the case. The challenges of index replication are most evident among high-yield, index-tracking ETFs.

Two funds have had dominant market shares in the US ETF high-yield market since their launches in 2007. Almost since their inception, the funds have shown significant tracking risk7 vs. the Bloomberg US Corporate High-Yield Bond Index.8 They have also meaningfully underperformed the Index, as reported by Morningstar (FIGURE 5). These funds may lag the Index because their benchmarks are more liquid than the Index and, therefore, can’t benefit as much from today’s hefty liquidity premiums; however, we think it’s appropriate to measure their returns vs. the Bloomberg US Corporate High-Yield Bond Index because it’s commonly used as a yardstick for the performance of high-yield portfolios.

 

FIGURE 5

Returns of Two Major High-Yield ETFs Vary Considerably From a Widely Used High-Yield Benchmark

12/31/07*–4/30/22

  Annualized return (%) Annualized tracking error (%)
Bloomberg US High Yield Corporate Index 6.62 N/A
ETF 1 4.96 2.10
ETF 2 4.72 1.80

* Earliest date that monthly data is available for both ETFs. Returns are net of fees. Sources: Morningstar, Bloomberg.

 

Conclusion

To summarize, we believe actively managed fixed-income portfolios have several distinct advantages over passive approaches:

  • Active core-plus and IG corporate managers have demonstrated the ability to outperform their benchmarks across numerous time frames.
  • Fixed-income markets tend to be fragmented and opaque with volatile liquidity—features that may benefit thoughtful investors.
  • The fixed-income indices commonly used as portfolio benchmarks expose investors to potentially costly index rules that force-sell issues falling below IG. Active managers have more flexibility on the timing of such trades and can often stay ahead of these situations.
  • Some so-called passive strategies can deviate meaningfully from the broad-market indices they purport to track in ways that cause them to underperform; high-yield ETFs are a prime example.
  • Greater dispersion among sectors, issuers, and individual securities provides more opportunities for active managers to potentially add value.
  • Finally, active managers are able to use market dislocations and inefficiencies to their advantage, whereas passive approaches must simply ride them out and endure the volatility.

 

To learn more about the benefits of active management in fixed income, talk to your financial professional.

 

1 The measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark.

2 We recognize that passive investing isn’t exactly the same as index-tracking. Passive investing features low turnover of portfolio securities compared to active approaches, resulting in relatively lower transaction costs. A low-turnover approach may be perfectly consistent with an investor’s objectives. However, to simplify terminology, this paper uses “passive” and “index-tracking” interchangeably.

3 Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

4 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.

5 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

6 Bloomberg US Corporate Investment Grade Bond Index covers all publicly issued, fixed-rate, nonconvertible, investment-grade debt.

7 Tracking risk is the difference between a portfolio’s price behavior and its benchmark’s price behavior.

8 Bloomberg US Corporate High-Yield Bond Index is an unmanaged broad-based market-value-weighted index that tracks the total-return performance of non-IG, fixed-rate, publicly placed, dollar-denominated and nonconvertible debt registered with the Securities and Exchange Commission.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities.

“Bloomberg®” and any Bloomberg Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by Hartford Funds. Bloomberg is not affiliated with Hartford Funds, and Bloomberg does not approve, endorse, review, or recommend any Hartford Funds product. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to Hartford Fund products.

The views expressed herein are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

WP496 2292739

About The Authors
Author Headshot
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

Author Headshot
Investment Director, Fixed income

The material on this site is for informational and educational purposes only. The material should not be considered tax or legal advice and is not to be relied on as a forecast. The material is also not a recommendation or advice regarding any particular security, strategy or product. Hartford Funds does not represent that any products or strategies discussed are appropriate for any particular investor so investors should seek their own professional advice before investing. Hartford Funds does not serve as a fiduciary. Content is current as of the publication date or date indicated, and may be superseded by subsequent market and economic conditions.

Investing involves risk, including the possible loss of principal. Investors should carefully consider a fund's investment objectives, risks, charges and expenses. This and other important information is contained in the mutual fund, or ETF summary prospectus and/or prospectus, which can be obtained from a financial professional and should be read carefully before investing.

Mutual funds are distributed by Hartford Funds Distributors, LLC (HFD), Member FINRA|SIPC. ETFs are distributed by ALPS Distributors, Inc. (ALPS). Advisory services may be provided by Hartford Funds Management Company, LLC (HFMC) or its wholly owned subsidiary, Lattice Strategies LLC (Lattice). Certain funds are sub-advised by Wellington Management Company LLP and/or Schroder Investment Management North America Inc (SIMNA). Schroder Investment Management North America Ltd. (SIMNA Ltd) serves as a secondary sub-adviser to certain funds. HFMC, Lattice, Wellington Management, SIMNA, and SIMNA Ltd. are all SEC registered investment advisers. Hartford Funds refers to HFD, Lattice, and HFMC, which are not affiliated with any sub-adviser or ALPS. The funds and other products referred to on this Site may be offered and sold only to persons in the United States and its territories.

© Copyright 2022 Hartford Funds Management Group, Inc. All Rights Reserved. Not FDIC Insured | No Bank Guarantee | May Lose Value