It pays to be active in fixed income

With the resurgence of inflation over the past several years, it’s been a very difficult environment to produce meaningful returns in fixed income. Duration exposure and curve positioning have driven much of the price action in bonds since 2022. But as the growth backdrop inevitably slows from elevated levels, fundamental credit analysis is likely to play a larger role in differentiating returns. I would argue this is the type of environment where active fixed income managers demonstrate their value.

When investing in a passive equity strategy that replicates a market cap–weighted equity index, in theory you are getting increased exposure to companies the market is rewarding and decreased exposure to companies the market is punishing. But investing in a strategy that replicates a market cap–weighted fixed income index does not have this feature. What you get instead is outsized exposure to the companies that are issuing the most debt. As there is often an observed inverse relationship between creditworthiness and amount of debt-securities outstanding, I would argue this is an undesirable characteristic – and is what is referred to as the “bums problem” in fixed income indices. I think it’s fair to say that this creates an easier hurdle for active managers to outperform fixed income indices compared to equity indices.
 

Active outperformance stats

This idea is supported by the percentage of active fixed income managers who outperform their respective benchmarks. Over the trailing 10-year time frame, 65% of intermediate core bond managers, 76% of high yield bond managers, 93% of bank loan managers and 94% of multisector bond managers outperform their benchmarks. Given the way these indices are constructed, it’s much easier for an active manager to differentiate a bond portfolio to deliver excess return compared to the benchmark relative to the equity space.
 

Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.
Source: Morningstar, Natixis Investment Managers Solutions*

Table legend:

• Row 1: Percent of active funds outperforming passive funds (%)
• Row 2: Average excess return (%)
• Row 3: Number of funds in category

Why does this matter now?

For as much as the market has made of inflation fears this year, credit markets have simply shrugged everything off. Credit spreads are relatively tight almost everywhere you look. This is a reflection of the fact that corporate balance sheets are exceptionally healthy and the growth backdrop has held up better than the market anticipated. But that won’t last forever. It’s likely we start to see that growth trend come back down to normalization toward the end of the year – perhaps we’re already seeing hints of this in the most recent economic data. And that timing might coincide with meaningful amounts of corporate debt needing to roll over and refinance. If we are still in a place where rates are higher for longer, you may finally start to see credit spreads react as the market anticipates a higher likelihood of corporate defaults. A good credit manager can earn their stripes in this backdrop by avoiding the issues where the juice isn’t worth the squeeze once the cycle turns.

Finally, as someone managing a tactical fixed income portfolio, I can attest to the fact that we remain in a fixed income market where it is difficult to capture and keep returns without actively managing your positioning. For example, the 10-year yield started in 2024 at about 3.94%, jumped up to 4.70% toward the end of April, and has settled back in around 4.20% as I write this in mid-June. I think you’ll continue to see yields bounce around like that in the near term while the market digests each incoming data point. If you can actively tilt that duration exposure, I believe there is a significant opportunity to add alpha. If you just buy and hold an index, a lot of that potential return could just come out in the wash.