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.