Bonds and the Information Premium
There are a few reasons that help explain why the active vs. passive story for fixed-income is different than for stocks. First and most importantly, the particular characteristics and market structure for each type of security help account for contrasting performance outcomes.
The universe of listed stocks in the United States amounts to only about 3,600 companies, with a total market capitalization of approximately $30 trillion. All public companies report their financial results according to GAAP rules, generally with quarterly frequency, and comply with fair disclosure rules. Moreover, publicly traded equities generally have exchange-based price discovery on a continuous basis. This relative homogeneity and transparency of financial data, news disclosures, and market data makes the equity market as close to an efficient market as it gets. In addition, most equity indexes are market-capitalization weighted, so they reflect the proportional size of each company in the index. Thus, while there are talented active equity managers who have consistently outperformed the index—and deserve to get paid for the alpha they generate—the market structure of equities makes it more challenging to gain any information premium.
The fixed-income universe, on the other hand, is sprawling, diverse, and huge. With approximately $43 trillion outstanding, it comprises 4.7 million non-matured CUSIPs as well as non-CUSIP debt instruments like bank loans. Most importantly, less than half of these securities are in the Agg, which is the primary index used to represent the broad U.S. fixed-income market.
Inclusion in the Agg requires that securities be U.S. dollar-denominated, investment-grade rated, fixed rate, taxable, and have above a minimum par amount of $300 million outstanding. At its inception in 1986, the Agg was a good proxy for the broad universe of fixed-income assets, which at the time primarily consisted of Treasurys, Agency bonds, Agency mortgage-backed securities (MBS), and investment-grade corporate bonds—all of which met the inclusion criteria. Sectors outside the Agg include many types of asset-backed securities (ABS), non-Agency residential MBS (RMBS), high-yield corporate bonds, leveraged loans, municipal bonds, and any security with a floating-rate coupon.
Unlike investment-grade corporates, Treasurys, and Agency securities, the non-indexed sectors of the fixed-income market have a wide range of structures, documentation, and reporting protocols. In addition, it is an over-the-counter market where pricing is less transparent. The complexity of the deal structures and security-specific collateral of certain securities, such as commercial ABS, CLOs, and bank loans, require proactive and comprehensive credit and legal analysis. It takes significant resources to take advantage of the opportunities in the non-indexed part of the market, which helps to explain why active management can realize the value of the inherent information premium, but passive management cannot.
Problems With the Agg: Follow the Leverage
A second factor that accounts for the different outcomes for active management in stocks and bonds is the structure of the Agg itself. The Agg still has its usefulness, but the bond market has evolved over the past 30-plus years. Rather than reflect the fixed-income universe in its current composition, the eligibility rules of the Agg—and other indexes that form the basis of passive investing—reflect a weighting that is tilted towards the activities of the largest debtors. In the late 1970s and into the early 1980s, the largest debt issuers were utilities, partly because of the big expansion in building nuclear plants. In the early 1980s, they started to default. Fast forward to the late 1990s and early 2000s when the largest debt issuers were the dotcoms and telecoms, and many of the largest issuers—like Global Crossing and WorldCom—failed. In the mid-2000s, some of the largest issuers were banks and financial institutions, many of which failed in the financial crisis. An index-following passive strategy would have held onto these securities until they dropped out of the index, whereas an alert active manager would have had the ability to trade out of these potential problems before they hurt client portfolios.
Today, the leverage bubble in the market is in corporate debt. A decade of ultra-easy monetary policy has led corporate issuers to accumulate record levels of debt, making them vulnerable to downgrades when the turn in the business cycle arrives. The problem is most acute in the investment-grade market, where nearly one third of nonfinancial debt outstanding has been issued by firms whose leverage multiples are already consistent with a high-yield rating. We expect a material dislocation in credit markets when a wave of issuers lose their investment-grade status and become “fallen angels.”
The impact will be far-reaching due to the sheer size of the problem. The indexed corporate bond market has grown to around $6 trillion, of which more than $3 trillion is rated BBB. Due to the large size and deteriorating quality of U.S. investment-grade corporate debt outstanding, the risks posed by a slew of rating downgrades are more pronounced today than at any time in the past 30 years. Given the record size of the BBB market, the potential fallen angel volume in the next downturn is the largest ever, exceeding the volume of fallen angels in the last cycle by two to three times. Like past debt bubbles, we believe this will have far-reaching macroeconomic implications that remain underappreciated today. Unfortunately, passive investment strategies with no ability to invest beyond the index are vulnerable to this risk.
The other major issue that has arisen because of the Agg’s eligibility rules is that it is increasingly concentrated in Treasury and Agency securities, which have become a central part of the fixed-income landscape since the financial crisis. The sheer glut of Treasurys and their dominant representation in the Agg is unlikely to reverse anytime soon—the need to fund present and future government deficits is significant. Index investors are vulnerable to interest rate and duration risk at current low yields. Even modest increases in rates would be sufficient for passive fixed-income strategies to incur losses.
Moving beyond the benchmark not only expands the possible investment universe to include other sectors for relative value, the diversification also enables an active manager to avoid problem sectors, particularly overindebted credits or unduly low-yielding categories. The flip side of more opportunity is greater risk avoidance.
The Active Fixed-Income Management Advantage: Risk Mitigation
The broader set of investment options available in the fixed-income market partly explains why active managers have been able to beat passive benchmarks. But it is up to the skill of the active fixed-income manager to know where to find relative value in the market and how to avoid problems that might not be evident from the weighting of indexes. The combination of these two attributes—the greater opportunity set and the ability of managers to make the right choices—is what provides the real advantage of active fixed-income management: risk mitigation.
Active fixed-income managers have the ability to properly position their portfolios as risks emerge and trading opportunities develop in a way that is not permissible for a passive strategy. For example, the impact of rate and yield curve changes on long duration assets can be managed with active decisions around portfolio duration positioning. Active managers also can dial up or dial down credit exposure over the course of a business cycle where appropriate. Right now, for example, with the risks lurking in BBB corporate credit and a recession possible as soon as the first half of 2020, our team has dialed down credit risk to the lowest allocation percentages in our history. In short, as an active manager without a tether to the benchmark, our goal is to position our portfolios to help protect client assets from drawdown risk by underweighting sectors that could negatively affect returns before anything happens. By definition, for passive fixed-income vehicles, this type of strategic positioning is simply not an option.
Risk mitigation is a central tenet of all active fixed-income investing because of the inherent difference in the return proposition of stocks versus bonds. In stocks, the goal is to try to find good companies whose value will appreciate over time—there are winners and losers, but a typical long investor is hoping for gains. If you pick the right stocks and market conditions are friendly, the upside can be rewarding. A passive strategy will reflect this general approach. For bonds, the risk and return is asymmetric. If an investor’s research is correct and everything goes as planned and no bonds default, over time the total return is the coupon and return of principal. The upside is limited, but the downside can be significant in the event of any deterioration in credit quality. For fixed-income investors, the object is to generate stable returns by playing what Charles Ellis famously termed a “loser’s game,” in which one wins by avoiding defaults and other “mistakes” rather than chasing returns.
As an example of how an active manager shifts allocations over the course of the cycle, the next chart shows the change in allocations in our Total Return Bond Fund over the course of the last cycle.
While Treasury and Agency representation in the Agg was rising over the last cycle, and as BBB-rated investment-grade corporate debt has increased in proportion more recently, our active management was seeking relative value throughout the fixed-income universe and trying to avoid problem areas. Driven by a comprehensive global macroeconomic outlook coupled with a detailed assessment of sector, industry, security, liquidity, and regulatory trends, we made many allocation changes during the last 10 years, most recently reducing our exposure to corporate credit in response to record—and in our view unsustainable—levels of corporate debt. Be wary of active managers that are really “closet indexers.” These managers masquerading as active will not employ the strategies we illustrate here.
Another way to look at active vs. passive strategies, again using our own history, is presented in the table below. In the first quarter of 2016, our Total Return Bond Fund was in risk-on mode, with close to 80 percent of assets allocated to structured credit and corporate credit. Today, these sectors have been cut in half as our portfolio team has upgraded credit quality, built liquidity buffers, and shortened spread duration. Conversely, the Agg has not changed that much. In addition, as the Agg’s relative duration increases, so does its exposure to interest rate risk.
Important Notices and Disclosures
This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion. Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC.
The Total Return Bond Fund may not be suitable for all investors. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing the value of the Fund’s holdings and share price to decline. Investors in asset-backed securities, including collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly. Investments in loans involve special types of risks, including credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. The Fund’s use of leverage, through borrowings or instruments such as derivatives, may cause the Fund to be more volatile and riskier than if it had not been leveraged. The more a Fund invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. Investments in reverse repurchase agreements expose the Fund to many of the same risks as leveraged instruments, such as derivatives. You may have a gain or loss when you sell your shares. Please read the prospectus for more detailed information regarding these and other risks.
Read a fund’s prospectus and summary prospectus (if available) carefully before investing. It contains the fund’s investment objectives, risks, charges, expenses and other information, which should be considered carefully before investing. Obtain a prospectus and summary prospectus (if available) at GuggenheimInvestments.com or call 800.820.0888.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, MBS (Agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS (Agency and non-Agency).
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Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC ("Guggenheim"). Guggenheim Funds Distributors, LLC is an affiliate of Guggenheim.
Read a prospectus and summary prospectus (if available) carefully before investing. It contains the investment objective, risks charges, expenses and the other information, which should be considered carefully before investing. To obtain a prospectus and summary prospectus (if available) click here or call 800.820.0888.
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*Assets under management is as of 09.30.2019 and includes leverage of $11.8bn. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC, an affiliate of Guggenheim, SI, GFIA and GPIM.
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