The Risk Mitigation Advantage in Active Fixed-Income Management 

Report Highlights

• In the long-running active vs. passive debate, the different characteristics and market structure for stocks and bonds help account for different performance outcomes.
• Unlike in equities, where passive strategies have generally outperformed active managers, active fixed-income managers have generally outperformed passive strategies.
• Risk mitigation is the real advantage of active fixed-income management. The opportunity set of investments outside of the fixed-income benchmark index, and the ability of managers to dial up or dial down risk, are not options for a passive strategy.
• Alert active fixed-income managers can trade out of potential problems before they hurt client portfolios.
• Using our own active portfolio management decisions as an example, we detail how an active approach has the potential to outperform passive strategies over time.

Active vs. Passive: It’s Different for Bonds

The rising flow of capital from active managers into passive, index-tracking investment vehicles has been accompanied by a similar rise in the number of papers and articles that defend or attack both styles of management. The active versus passive debate has raged since Vanguard’s John Bogle introduced the first index fund in 1976, but now that nearly half of all U.S. stock fund assets are invested in mutual funds and exchange-traded funds that passively track indexes, some would say that the market has spoken and the matter is settled. The issue is not insignificant, for it speaks to the important decision that investors make when choosing to allocate their assets to different strategies. In this case, the choice between active management and passive management reflects an investor’s tolerance for risk, expectations for returns, and in many cases, preferences on fee structures.

Indeed, the flow of capital into passive structures has become pronounced in recent years, particularly for equities. The divergence in market demand and flows for mutual funds shows differing sentiment between equities and fixed income.

The flows data story is reflected in the performance data. The historical track record shows that for stocks, passive index-tracking vehicles have generally outperformed active managers. As the chart below shows, over the past 10 years, the average active large-cap equity fund manager has underperformed the benchmark index 78 percent of the time. In contrast, over the same 10-year period, the average active intermediate-term bond fund manager has outperformed its benchmark, the Bloomberg U.S. Aggregate Bond Index (the Agg), 60 percent of the time.

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.

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. Guggenheim Investments’ approach means we generally allocate to sectors that are under-represented in the Agg but which we believe have the potential to generate excess returns for our clients. 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 goal 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 Guggenheim Return Bond Fund over the course of time.

For comparison, the chart below shows the evolution in the Agg over the same period: Fewer colors/sectors, less movement….and as we will see later, lower returns to investors.

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 to potentially capitalize on opportunities while avoiding 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 an up-in-quality rotation in line with our broader defensive view. 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 next illustration. 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. Leading up to the COVID-led recession the portfolio managers had shifted into risk-off mode, reducing credit risk and making larger allocations to short-term investments and government-related securities.

Immediately after the COVID-related sell-off and the expansion began, the Total Return Bond Fund ramped up risk again. In these examples, while we could not have predicted that COVID would be the catalyst, active management both anticipated a recession and responded to changes in market conditions. While there is no guarantee that an active manager’s views will prove correct or produce the desired results, which could lead to underperformance, at all times a focus on relative value and which risks you are being compensated for—and to what degree—will drive allocation decisions.

Results Tip Toward Active Managers

There will be periods when the Agg will outperform an active fixed-income manager, but over a cycle a capable active manager should be able to find opportunity in order to seek better results for their clients.

While past performance is no guarantee of future results, our own experience versus the Agg is shown in the following chart.

In conclusion, rather than buying the benchmark and hoping for the best, we believe that fixed-income investors are better served allocating their assets to an active strategy. With mounting economic and market risks, this is no time to be an indexer. As active managers, we believe that by sticking to long term, thoughtful, and conservative underwriting standards we can prepare to ride out bumpier times. And by deploying portfolio level risk mitigation strategies we can position strategies to pick up potentially undervalued credits and be opportunistic when the time is right.