Active outperformance over such a lengthy period, spanning turns in the credit cycle, suggests factors at play beyond an emphasis on credit. Indeed, active managers have many other levers for seeking to generate alpha, such as sector rotation, out-of-benchmark allocations, duration positioning, security selection, and (in the case of global strategies) country and currency selection. These noncredit levers may also mitigate drawdowns during credit-adverse environments.
That said, credit overweights have clearly helped boost excess returns delivered by active managers over most periods — the great exceptions in the past 20 years being the global financial crisis (GFC) and COVID pandemic. Recouping of the spread widening emerging from these drawdown periods compensated for active managers’ shortfalls versus index returns in 2008 and early 2020. While the median active manager’s performance versus the index tends to be positively correlated to credit spreads — outpacing the index when spreads narrow and lagging when spreads widen — periods of underperformance have often been short-lived and typically outweighed by longer stretches of outperformance.
Reason #2: Market structure
Fixed income markets tend to be fragmented and opaque, prone to experiencing volatile liquidity. However, these features may benefit thoughtful investors by increasing the premia they can earn through portfolio implementation and active management (Figure 2).
Fragmented: Unlike equity markets, there is no “central” fixed income exchange. Instead, securities are still traded “over the counter” (OTC). This often requires a trading desk to strategically plan how it will either buy or sell a bond, allowing the implementation aspect of investing to potentially add value. Moreover, issuers may have different bonds in various parts of their capital structure or in varying currencies and maturities. A single corporate or government issuer may have numerous individual bonds, each with different terms and conditions. That can mean the risks and rewards differ as well. A passive exposure does very little to distinguish among those individual bonds.
Noneconomic actors: Some key participants in fixed income markets are looking to achieve objectives other than a rate of return. These include central banks and the US Treasury, along with commercial banks and insurance companies that may be subject to investment constraints imposed by the regulatory framework. Hence, these counterparties are often not trading based on valuations, leaving room for active investors to purchase or sell bonds at opportune times.
Liquidity and balance sheet: Reductions in dealer balance sheets following the GFC have made liquidity more variable across fixed income markets. Given that there is no central fixed income venue, investors rely on dealers to serve as counterparties for trades and to hold inventories of bonds. The reduced ability of a dealer to “intermediate” or serve as a place to store inventory means bond prices can be influenced by the noneconomic actors, providing the opportunity for an active investor to supply liquidity when traditional intermediaries cannot and to do so more effectively than passive investing.
Implementation: Fixed income markets provide a number of ways for skilled practitioners to add value through implementation, many of which are not replicable in passive terms. Issuer, CUSIP, and maturity are all important facets of a decision. In addition, active investors can decide whether the exposure looks better in cash (“funded”) format or through derivatives such as futures (“unfunded”) and can seek to exploit differentials between the two. Similar dynamics exist for currency markets, where lending dollars via the cross-currency basis market may deliver robust risk-adjusted returns. Over time, these and other tactics have often translated into superior results versus passive exposure.
