by James Moore
In the active-versus-passive debate, investment flows suggest passive has been winning. And many, if not most, investors seem to believe the rationale for passive applies equally well to fixed income as equities. But bonds are different. And we believe the case for active fixed income management has only been strengthened by the uncertainty and volatility that President Donald Trump’s policies may engender.
The active-versus-passive debate is an old one, of course, with reasoned arguments on both sides. On a visceral level, in recent years many investors paid active equity management fees only to get below-benchmark returns.
Basic math lies at the core of the logical argument for passive: In sum, the performance of all investors aggregates to the performance of the markets. For every winner, there must be a loser subsidizing a winner’s gains. Throw in fees, and the average net return above the market for active investors is negative.
Bonds are different for multiple reasons. Bond investors have varying objectives, which is seldom the case for equities. Trading dynamics differ. New issues, and their magnitude within benchmarks, are more significant factors. And the return profile of individual bonds is far more skewed than it is for equities. For these and other reasons, we believe the case for active fixed income management is persuasive. Let’s take a closer look:
1) A significant fraction of investors in fixed income markets have primary objectives that differ from maximizing mark-to-market total returns.
Central banks, for instance, buy and sell foreign bonds to stabilize exchange rates and trade domestic-currency sovereign bonds to manage the money supply. Commercial banks and insurance companies often invest based on returns on risk capital, agency credit ratings and accounting conventions. They seek predictable, steady income – mainly from coupon payments; they generally shun capital gains and losses, earnings that equity analysts often regard as lower quality. The majority of these investors also treat the investment grade threshold (triple-B-minus/double-B-plus) as a perilous cliff best avoided.
Figure 1 summarizes the fixed income balances held by these investors. Note that of total global fixed income assets of about $102 trillion as of 30 June 2016, as reported by the Bank for International Settlements, nearly half is held by non-mark-to-market investors.
To the extent these objectives differ from those of pure mark-to-market investors or these constraints come with some embedded cost, some value must be transferred to those not similarly constrained.
2) Unlike equity indexes, where the market determines the weights, in bond indexes issuers principally determine the weights.
With the exception of the Dow Jones Industrial Average, most commonly referenced equity benchmarks are capitalization weighted, with weights determined solely by the market capitalization of the companies. Most companies have a single publicly traded share class, or two at most.
Bond indexes are different. Weightings chiefly reflect how much debt a company or government issues and the size of an individual security issued. Yet if a company issues more debt, the aggregate value of the enterprise is not fundamentally affected: Cash coming in is an asset; debt added is a liability. Ignoring issuance fees, new cash – new debt = 0. However, when a company issues more debt, its weight in a bond index increases. Why should a company’s decisions on capital structure drive an investor’s decision to hold its bonds? Why should an investor boost holdings in a company’s liabilities because the company increases financial leverage?
Imagine triple-B-rated Acme Enterprises decides to issue $1 billion to fund a new factory for roadrunner traps. Given its cash flow forecasts and advice from its bankers, the company issues $500 million in five-year, $300 million in 10-year and $200 million in 30-year bonds. Bloomberg Barclays Credit and Aggregate indexes would increase Acme’s representation by $800 million – not $1 billion – because inclusion in the index requires a minimum amount outstanding of $250 million (rising to $300 million in April). This disqualifies the 30-year bonds, whose pricing is therefore affected because index buyers will not hold them.
Across the corporate universe, there are companies with a single equity share class that is included in one or more equity indexes and with dozens, if not hundreds, of individual debt issues. However, the fraction of their debt included in indexes may vary widely.
3) The new issuance market is much more important for bonds than equities
In the year ended 30 September 2016, total U.S. corporate bond issuance was approximately $1.55 trillion against an outstanding balance of $8.55 trillion, according to the Securities Industry and Financial Markets Association and Bloomberg, while U.S. equity issuance was $190 billion against a total market value of over $24 trillion (much less if secondary equity offerings are excluded). Thus, new securities make up about 18% of bond market capitalization; in the equity markets, new issues are less than 1%. This stands to reason as common equity is generally a perpetually lived security whereas bonds have finite maturities. Thus, an active presence in the issuance market can materially affect performance for fixed income investors, whereas its contribution to equity performance is rarely more than a rounding error.
As new bonds typically come to market at a slight discount to outstanding issues, a strong presence in the new-issue market can add incremental value for two reasons. First, although size matters, investment banks do not treat all comers equally – allocations are not made pro-rata or based solely on an investor’s size. A host of other factors contribute to a successful syndication. Second, after issuance not all new issues will tighten, or increase in price, equally. Knowing when to participate aggressively in a new issue or to pass requires strong credit analysis and an understanding of trading technicals.4) Most bond trading occurs via over-the-counter transactions and not on exchanges
Exchanges work when the number of listed securities is manageable and a high degree of standardization exists. At the end of 2016, MSCI’s All Country World Index listed 14,447 equities, covering 99% of the global equity opportunity set. Bonds are different: PIMCO’s databases track more than 344,000 fixed income securities in all currencies, and we are constantly adding new ones. Bonds from a single issuer may vary in terms of covenants or indentures. Two current 10-year bonds from a single issuer may not be perfect substitutes depending on when they were issued, if they were from a merged predecessor company, or due to other reasons!
Therefore, the majority of bond purchases and sales are not simple orders, but negotiations. The outcome is determined not only by the object of interest, but also by factors affecting the two parties negotiating. Research by Edwards et al.1 (2007) documents a host of factors affecting bid-ask spreads and clearly suggests that size is a significant advantage in execution.5) Individual bond returns are highly skewed versus stock returns, which are more symmetric
In the short run, the expected path of any given stock conforms roughly to a random walk with a long-term upward trend. Consequently, when aggregating individual holdings in portfolios, the rate of convergence under the law of large numbers (LLN) is fairly rapid.
Bond returns are quite different. In most cases, the most a bond can return is principal and interest earned until reaching maturity. But some return far less due to default, (forced) premature sales due to a credit rating downgrade, and other reasons. Aggregating across holdings, convergence under the LLN can be slow. The higher the quality of the index, the slower convergence will be.
In active management, a manager can potentially add alpha to a fixed income portfolio by playing offense when the time and circumstances warrant, but a significant amount of value, if not the majority, is typically added by strong defense.
There are many other ways active managers can add value – including by the prudent use of derivatives as substitutes for cash bonds and by understanding misvalued embedded options and risk premia due to policy or regulatory factors. These and other characteristics help explain why the median active manager of intermediate-term U.S. bonds in the U.S. outperformed its passive counterpart over the 10 years ended last December, according to Morningstar.2
Importantly, active managers can seek to mitigate volatility, which is likely to remain high. The Federal Reserve’s hiking cycle has begun, and the evolution and impact of Trump’s policies remain uncertain. As noted in our recent Cyclical Outlook, we believe the probability of both left-tail (downside) and right-tail (upside) macro outcomes has increased. In the end, the key question for investors is, “Do I have strong reason to believe my active managers will add value in excess of fees?” I would not argue that all do or even that a majority do, but those managers who understand and exploit the five reasons above, plus a host of others, stand a very good chance.
So much for common wisdom.
1 Amy Edwards, Lawrence E. Harris and Michael S. Piwowar, “Corporate Bond Market Transaction Costs and Transparency,” Journal of Finance, v 62 (3) June 2007, 1421-51.
2 Based on Morningstar U.S. Intermediate-Term Bond Category for the Institutional share class, after fees. The median active manager returned 4.70% and the median passive manager returned 4.19% for the period.