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.

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.

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.

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.

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.