Maximizing Returns: How Active Investing in Bonds Triumphs Over Passive Strategies
Welcome to the elaborate world of bond investments, where strategic decisions define future returns. At the core of bond investment strategies lies the iShares Core U.S. Aggregate Bond ETF, commonly referred to as the Agg. This ETF forms the foundation of passive bond investing, mirroring the vast landscape of the US investment grade bond market. With millions of investors utilizing its capabilities, the Agg provides access to various bonds passively.
Within this domain, a thought-provoking narrative emerges, challenging the conventional wisdom of passive investment strategies, specifically within bonds. While passive investing in equities is effective in providing low-cost exposure to a broad basket of securities, its effectiveness in the world of bonds is subject to debate. This distinction prompts us to delve deeper into the dynamic between active and passive strategies within the realm of bond investments.
Passive Strategies – Great for equities, not bonds:
Passive strategies that track a particular index give investors the ability to gain low-cost exposure to a basket of securities and produce market-like returns. A common example of this would be the SPDR S&P 500 ETF Trust (“SPY”), which mimics the performance of the S&P 500. In the case of the S&P 500, the underlying securities in the index are weighted based on market cap, with the largest US companies making up the largest percentage of the total index. As the market cap of a company changes, its weight in the index will change proportionally. In the case of the Agg and many other bond indices, they are weighted based on outstanding debt, meaning we see a large concentration in US treasuries and mortgages (65%) since they make up most of the market.
It is important to understand that bonds and equities are inherently different in their structure, even if they are from the same issuer. Shares of common stock are all identical, with the investor owning a certain percentage of the company. Since they are all the same, stock indices are easily constructed. Bonds on the other hand are not all the same. They can have different coupon rates, term lengths, embedded options, collateral, etc. These factors will influence the price and yield to maturity (YTM) of the bonds. Additionally, bonds are not perpetual, meaning they all have some sort of term. Bonds will mature at some point whereas stocks are perpetual and will continue to exist unless the company goes bankrupt. Since bonds mature, they are eventually replaced with new bonds that are entirely different in their structure and interest rates. Bonds therefore have a higher turnover than stocks, which creates problems when constructing an index. The balance sheets of borrowers change frequently as well, creating potential problems when replicating an index based on the market value of debt outstanding. One company may borrow $10 million, and one may borrow $10 billion. Should the company borrowing $10 billion truly have a higher weighting than the one borrowing $10 million? In many bond indices, the answer is yes. This could result in buying the bonds of companies with too much debt, potentially resulting in solvency issues and permanent loss of capital for the investor.
Overall, the biggest issue with passive bond investing is the structure of the index. There is not a good structure that can be replicated for cheap. This is a structure of how bonds are all different and the sheer volume of bonds to choose from. Liquidity can also create issues. While treasuries are typically highly liquid, some thinly traded corporate bonds may have much less liquidity and in turn, create problems when buying and selling. While stocks typically have a very small bid/ask spread, bonds with less liquidity can often have very high spreads, meaning it will be much harder to sell at the price they are asking.
Benefits of Actively Managed Bond Funds:
Understanding that passive funds like the Agg have shortfalls, we can now talk about why an actively managed bond fund makes more sense for investors looking to maximize returns. One benefit of an actively managed fund is that the manager can control the portfolio’s duration (bond’s price sensitivity to changes in interest rates) or yield curve positioning. Active managers can sell long-term bonds to buy shorter-term bonds to lower the portfolio’s duration in the event of a rising interest rate environment to protect on the downside. A skilled manager can also position the portfolio in a way that allows them to be opportunistic or defensive with what they own. For example, they can rotate sectors to take advantage of areas that have underperformed or areas that are more likely to hold up in a downturn. Knowing that all bonds are different, a manager can also perform fundamental analysis on the issuing companies. The same bond issuer may have two bonds – one may be attractive because it is the first lien, and one may not be attractive because it is further down the capital structure. While the management fees are higher in an active strategy than in a passive strategy, traders can make up for this through the prices they buy and sell securities at, taking advantage of mispriced securities. Active managers have more “buying power” when it comes to spread. If the spread is wide on a big piece of debt, active managers can often negotiate the price whereas a smaller buyer may not have that ability. Additionally, active managers can increase the yield on the portfolio relative to the index to help cover the management fees. That said, the flexibility and adaptability of an active bond manager can make a difference.
In the world of bond investments, the stark contrast between active and passive strategies unveils a compelling narrative. While passive indexing serves as a formidable low-cost option in equities, its limitations become apparent within the bond market. Knowing the shortfalls of a passive bond fund such as the Agg, investors should always look towards active management for fixed income exposure to take advantage of the inefficiencies in the market and enhance returns.
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