Why an active approach matters in fixed income?

While passive investments have seen rapid growth in recent years, we believe there are several crucial advantages for choosing active management when investing in fixed income. This is especially true in the current climate, as uncertainty over the future path of interest rates and inflation continues to drive heightened volatility across the asset class. How active bond managers can add value?

We believe that fundamental credit analysis is a key driver of relative performance, as it is only through this process that investors are able to gain a thorough understanding of a company’s financial situation and business model. With one of the largest teams of credit analysts in Europe, we believe M&G is particularly well placed to identify the companies and sectors that should be in the strongest position to perform in a variety of economic scenarios, including a prolonged economic downturn.

As part of their assessment, our credit analysts consider all factors that could have an impact on a company’s financial performance, covering areas such as business risk (management, market position and product strategy, for example), financial risk (such as cashflow, debt and profit margins) and bond structure and covenants. In addition, our analysts carry out a detailed assessment of environmental, social and governance (ESG) factors.

Active managers also typically benefit from greater flexibility, giving them the freedom to adjust portfolio positioning in accordance with the economic environment. The ability to adjust sector and company exposure, benefit from careful bottom-up security selection and position portfolios to seek to minimise the impact of rising interest rates provides active managers with crucial levers to take advantage of the investment opportunities – something not afforded to passively manged funds.

Active managers have the flexibility to capture a broad range of relative value opportunities that can often exist across fixed income markets. One of the ways in which we seek to do this is by comparing different bonds from the same issuer (such as those issued in different currencies or maturities) in order to take advantage of pricing mismatches, which can often occur during periods of market volatility. We may also be able to identify instances when similar companies (those in the same sector and with similar credit metrics) trade at different valuations. Another example is where the spreads offered by physical corporate bonds can sometimes differ from what is available through the credit default swap (“CDS”) market.

Active managers are also well-placed to capitalise on the additional yield pick-up that issuers typically offer when pricing new issues versus their existing debt. We believe this is a key area where active managers can add value versus their passive counterparts.

Passive bond funds have seen steady growth in recent years, but we believe there are a number of reasons why fixed income may not always be suitable for a passive approach. We explain below some of the shortcomings of passive fixed income.

While an equity index tracker will typically be weighted towards a market’s biggest and arguably most profitable corporations, a bond index by contrast gives exposure to the most indebted governments or companies – so-called ‘sinners, not winners’. For example, the largest constituents of a typical corporate bond index will usually be those with the largest outstanding amounts of debt – far from the type of issuer to which investors may choose to have a sizeable exposure.

It is also a common misconception that credit indices are, by definition, well diversified. They actually have a poor diversification. The ICE BofAML Global High Yield Index, for example, has an exposure of around 80% to US dollar denominated assets, making it very reliant on the US economy and highly exposed to oil prices. In another example, the ICE BofAML European Investment Grade Credit Index has some 40% exposure to financials. This highlights why investors must be careful to look through to the underlying assets to make sure that they are gaining an exposure that corresponds with their appetite for risk – as well as providing them with sufficient diversification.

Recent market volatility has again highlighted the dislocations that can occur between fixed income ETF prices and their underlying net asset values (NAVs). During sharp market sell-offs, there have been instances where ETFs have lagged their underlying benchmarks as the market is unable to absorb large amounts of selling. During severe sell-offs, there have even been cases when ETF prices have fallen below their NAVs. Furthermore, unlike active managers, index funds are fully invested and therefore cannot hold cash and other liquid instruments to act as a buffer against market falls.

To varying degrees, active bond managers have the ability to adjust portfolio positioning depending on their macro outlook and their assessment of valuations. For instance, they may choose to reduce interest rate risk to mitigate the risk of rising interest rates, or to move into higher quality credits where they have concerns over the economic backdrop. Passive bond strategies do not have the ability adjust exposure in this way; instead, they will seek to match the interest rate and credit risk of a specific bond index.

As noted above, market volatility has created significant spread dispersion across credit markets. This type of environment can create an abundance of opportunities for active managers to capture value, but this is not something passive bond vehicles are able to exploit. Similarly, passive managers would not usually have the flexibility to sell a position, whether due to a deterioration in its credit profile or simply on valuations grounds.

Opinion tribune by Jim Leaviss, CIO of M&G Investments’ Public Fixed Income.

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• M&G Investments