Outside-IN

Passive fixed-income strategies? Not in today's environment

Value of active strategies comes from identifying value with respect to credit risk, interest rate levels and currency valuations.

Oct 21, 2014 @ 7:26 am

By Thomas Hoops

There are many excellent ways to invest in fixed income in the current market environment. Passive strategies are not among them.

Investors should seek out experienced professionals who know the global fixed-income markets, can anticipate and act upon the impacts of rate increases and currency fluctuations, can actively manage downside and seize upon opportunities when they arise.

Can passive fixed income strategies do this? No. Worse, the limits of fixed-income benchmarks can expose investors to significant downside risk in rising rate environments.

Passive equity strategies, particularly for large cap stocks, track easily-understood benchmarks like the S&P 500. Indexed stocks are often weighted by market capitalization and, while they also have their own set of limitations, they are at least economic meritocracies: the companies with the largest weightings have seen their market values rise through profitability and growth, have made money for their investors and have risen to positions of respect and prominence.

Fixed-income indexes, by contrast, are constructed according to debt issuance patterns rather than any real sense of an issuer's value. Most are weighted by the amount of debt issued – with the biggest constituents of the index being the companies or countries that issue the most debt. Are the largest debtors always the best performers? Of course not. Unfortunately, I fear that most clients do not understand the inherent risks they are taking when they are systematically overweight the most indebted issuers.

We expect global interest rates to rise, probably slowly, over the next 18 to 24 months. However, broad-market passive fixed income strategies put investors in the way of rising rates: capital losses can potentially eliminate income. This can also be true even with short-duration passive strategies.

The most popular U.S. fixed-income index, the Barclays Aggregate, is limited to Treasuries, agencies, agency mortgage-backed securities and investment-grade corporates. Those sectors comprise only 35% of the investible universe of fixed income, limiting opportunities to enhance yields and diversify. Given the index's current yield and duration, a rate increase of only 25 basis points could wipe out a year's income, because passive managers cannot effectively manage duration, diversify the portfolio or hedge exposure.

Because the other bond sectors in the index are highly correlated to U.S. Treasury price performance, they also provide little protection when interest rates rise. Passive strategies based on the Barclay's Aggregate today offer a low yield, long duration and limited effective diversification – the opposite of what most investors want.

The same dynamic is true in international markets. The performance of global bonds are inherently tied to the issuer's home currency. In international indexes, a country's weight rises as its currency appreciates. This can create a bias toward markets with overvalued currencies. In addition to not hedging currency risk, passive global fixed income strategies incorporate only sovereign bonds, eliminating the yield and diversification opportunities in credit.

To be fair, passive fixed income strategies may make sense for some, chiefly those who want simple exposure to U.S. Treasury bonds and their home currency. Because these products need little management they can be offered at very low fees.

But investors seeking the full benefits of bonds – including income, portfolio diversification and capital protection in various rate scenarios – need the guidance that active management can offer.

Strong active managers seek opportunities when available and look to avoid risks when advisable, whether the interest rate environment is high or low. Asset managers who have the experience and skill to manage currencies can capture much more complex relationships and diversify their sources of return.

A truly diversified global fixed-income program can utilize floating-rate securities (whose coupons increase when rates rise), high-yield securities and the full range of bonds issued outside the U.S. This would include navigating credit and currency risks to capture historically higher yields in the growing emerging market economies. All of this can create enhanced potential for outperformance.

Success in global fixed-income investing relies as much on avoiding loss as pursuing gain. This can mean turning away from a country that is a large constituent of a popular index, believing their bonds will underperform. It can also mean having the courage of conviction to concentrate on less-popular countries and currencies because they represent greater total return opportunities. Concentration in this situation need not equal risk; the opposite may be true.

The value of active strategies comes from identifying intrinsic value with respect to credit risk, interest rate levels and currency valuations. Only rigorous analysis will demonstrate the full structural strength and weakness of a country's economy, its exposure to worldwide and regional market dynamics and determine the real yield possibilities available through its bonds. This is as true for the U.S. and the developed world as it is for emerging markets.

None of this can be accomplished through passive fixed income strategies. Caveat emptor.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.

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