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 3,000 companies in the United States, with a total market capitalization of approximately $44 trillion1. 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, 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 $55 trillion outstanding2. 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 that are predominantly 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. 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. These sectors have the potential to compensate investors for the extra work—usually from higher spreads/yields or additional structural protections. It takes significant resources to try to take advantage of the opportunities in the non-indexed part of the market, which helps to explain why active management and managers who specialize in these markets may 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.
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. Treasurys comprised 50 percent of the Agg as of Dec. 31, 2022, which, when combined with Agency securities, brings the weighting of U.S. government-related debt to 73 percent. 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.
Moving beyond the benchmark not only expands the possible investment universe to include other sectors for relative value, but the diversification also enables an active manager to mitigate concentration risk and introduce other levers to generate returns.
Important Notices and Disclosures
1. Source: SIFMA. Data as of 3.31.2023.
2. Source: SIFMA, S&P LCD, Bloomberg. Excludes sovereigns, supranationals, and covered bonds. Data as of 12.31.2022
*There is no guarantee that an active manager’s views will produce the desired results or expected returns, which may lead to under-performance. Actively managed investments generally charge higher fees than passive strategies, which could affect performance. In addition, active and frequent trading that can accompany active management, also called “high turnover,” may lead to higher brokerage costs and have a negative impact on performance. Further, active and frequent trading may lead to adverse tax consequences.
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, 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 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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*Assets under management is as of 3.31.2023 and includes leverage of $14.7bn. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management. Securities offered through Guggenheim Funds Distributors, LLC.
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