The most common mistake in a fixed income strategy would be to treat it as if it were a relatively homogeneous asset class.
Government bonds, investment-grade credit, high yield, inflation-linked bonds, and cash-like instruments all play very different roles in a portfolio, so simply ‘having a bond fund’ is not the same as building a well-constructed fixed income allocation.
Another mistake, according to Craig Veysey, fixed income fund manager at Guinness Global Investors, is focusing too heavily on yield in isolation: “Starting yield matters, but it is not the whole story”.
Advisers also need to think about duration, credit quality, liquidity and how the fund is likely to behave in different market environments.
Risks of chasing yield
Chasing a higher yield can often mean taking on more credit risk, more duration risk, or less liquidity than the client actually needs.
Assuming that benchmark exposure automatically gives sensible diversification is another misconception.
In fixed income, indices are typically weighted by debt outstanding, which means investors often end up lending the most to the biggest borrowers rather than to the most attractive risk-adjusted opportunities.
That can matter particularly in retirement portfolios, where capital preservation and resilience are often as important as income.
Liquidity also matters enormously, Veysey explains, as not all fixed income products offer the same underlying liquidity, and advisers should understand what sits beneath the headline yield.
He says: “In more volatile markets, the liquidity of the underlying holdings and the flexibility of the fund can make a significant difference to outcomes.
“For advisers building portfolios, the practical takeaway is that bond allocations should be designed around function, not labels.
“The key questions are: what role is the allocation meant to play, how much risk is really being taken to earn the yield, and how resilient is the portfolio likely to be if markets become more volatile?”
Bond benchmarks and portfolio distortion
With indices typically weighted by debt outstanding, this provides a strong case for active management in fixed income strategies, although passives still have a role too.
Pointing to peer returns for most sectors over the past decade, David Roberts, head of fixed income at Nedgroup Investments, says that while there is consistent evidence that active managers outperform in fixed income, this comes with a caveat.
“Most multi-sector bond funds — the ones that can buy credit and rates — tend to be modestly pro-risk, with a higher weighting to credit/corporate debt than global indices,” Roberts says.
“Corporate debt generally outperforms sovereign, so a long-term overweight will normally add value, albeit with wobbles, for example, around ‘liberation day’ or as seen in recent days with Iran.”
The practical takeaway is that bond allocations should be designed around function, not labels
Veysey argues that while the evidence is mixed, fixed income is generally one of the areas where there is a strong structural case for active management.
As mentioned previously, bond indices are typically weighted by debt outstanding.
This means the biggest weightings in a bond index are the companies with the largest amount of loan issuance, so index investors can end up highly exposed to the most indebted companies.
This comes with corporate risks, such as being overly exposed in a recessionary environment, refinancing risk and reduced operational flexibility, to name just a few.
Value in active management
Active managers, on the other hand, have more opportunities to avoid these risks.
“Where active management has the clearest opportunity to add value is in less efficient parts of the market, and in areas where benchmark construction creates structural distortions,” says Veysey.
“That is one reason active management can be especially valuable in fixed income.”
But active management is not just about avoiding benchmark distortions. It is also about having the freedom to take a more conviction-led, valuation-focused approach.
Veysey adds: “In credit markets, especially, the best opportunities are often specific bonds or issuers where spreads more than compensate for the credit risk being taken, or where an identifiable catalyst can unlock value over time.
“That is very different from owning a broad basket of debt simply because it is heavily represented in an index.”
As a result, Veysey says that active management is most useful where managers can combine bond selection with a clear quality bias, focusing on mispriced opportunities rather than simply reaching for yield.
It also matters, he adds, where they can manage duration actively, reduce credit risk when spreads are very tight, and shift portfolio quality as the cycle evolves: “In a market where the quality of return matters as much as the headline yield, that flexibility has real value.”
A role for passives?
At Quilter Cheviot, Richard Carter, head of fixed interest research, says they invest passively in fixed income markets, adding that the range of options has increased notably in recent years, with a number of low-cost vehicles available.
Yet, his experience is that active managers can offer good value for money in areas like sterling credit, where the market is quite inefficient, and the underlying indices are dominated by the most indebted companies.
Dan Caps runs the Index MPS range at Evelyn Partners, which specifically uses passives, however, he says more broadly both active and passive funds can play a part in constructing a well-balanced fixed interest allocation.
“While passive funds can provide cheap exposure, there can also be opportunities for active managers in fixed interest,” Caps says. “What is most important is an active approach to managing the exposure to the asset class overall.”
The proliferation of different exposures that have launched in recent years, especially in the passive space, has given portfolio managers more tools than ever before to help construct portfolios in line with their asset allocation view.
Ima Jackson-Obot is deputy features editor at FT Adviser
