The perils of passive bond investing

There are plenty of reasons to hold bonds in a portfolio, however, with bonds, perhaps even more than equities, there is merit to an active investment strategy rather than a passive approach. This is particularly true at times like these; when interest rates are rising, and policy uncertainty is high.

Both government and corporate bonds prices have fallen in 2022 across most geographies - there has been no place to hide. Yet, the rise in yields has meant that there are now some attractive opportunities appearing in corporate bonds. Since the yield curve has risen so sharply at the short-end, there are some investment grade corporate bonds that yield 4+% with one-year duration, and high-yield bonds that can offer around 9% over the same horizon. These opportunities are not available on a passive basis - you need an active, opportunistic fund manager who can buy the most attractive bonds.

As yields rise there are likely to be corporate defaults. Companies may not be able to refinance their borrowing at the new higher interest rates. As opposed to passive equity funds, which typically weight their components according to market capitalisation - favouring the strongest companies; passive bond funds tend to weight their holdings by the amount of debt outstanding - favouring the most indebted companies. If we are to see a default cycle, then active funds that are positioned to the strongest companies ought to be less exposed.

With the current investment landscape so uncertain, some active bond fund managers are able to include sophisticated hedging instruments. Products like swaps and options can help protect the fund if markets move against them and allows them to artificially increase their positions if they wish. Passive funds do not have this capability.

Not only can active funds access strategies that passive funds cannot, but they are able to be more nimble. The central banks are always key to financial markets, but we are now in a time where central banks are hiking rates, and hiking by large increments - 2022 saw the first 75bp hike since 1994. This environment means that the ability to be agile and alter a fund's exposure quickly is a major advantage and a luxury that passive bond funds do not have.

When active funds have a broad remit, they are able to allocate appropriately between different exposures, such as corporate and government debt, or different geographies. Passive investors may be able to access these exposures via a combination of index-tracking products, but may not be able to easily adjust their weights quickly and may not have the expertise to do so effectively.

There is always a good argument to favour active bonds funds over passive, but the case is particularly strong at the moment, and will continue to be if we are entering a period of higher rates and greater uncertainty.