27th January 2023
Assuming you are able to find the good ones, we are unashamed advocates of active managers, but recognising the polarising nature of the argument, has tended to keep our counsel on the whole active versus passive debate. It’s with a degree of trepidation therefore, that this week’s Crescendo explores why active investing might have particular merit in credit markets and especially in the environment we find ourselves in today.
There are a number of well-rehearsed arguments as to why there might be structural reasons to avoid accessing corporate bonds via a passive approach. The first is that position sizing in passive credit funds tends to be determined by the amount of debt in issue, which results in the rather perverse outcome of trackers having the greatest exposure to companies with the most debt.
Secondly, corporate bond indices tend to be more diverse than equity indices with a larger number of constituents and greater turnover, which combined with poorer bond market liquidity and wider bid-offer spreads, results in significant hidden costs for passive credit funds that seek to replicate an index. This turnover and the concept of fallen angels and rising stars also results in passive approaches mechanistically buying and selling credits, often at the worst possible time from a value perspective. Many passive credit funds, seeking to mitigate the costs associated with full replication, will employ a form of stratified sampling by focussing on only the most liquid bonds in an index. This can result in non-rational moves in individual bond prices, with liquid names benefitting the most when flows are positive but getting hit the hardest when sentiment sours and flows turn negative. The huge amount of capital managed by passive corporate bond funds today and the way in which they buy and sell indiscriminately inevitably creates opportunities for active managers to exploit, in the same way they can take advantage of other non-economic actors in the market such as pension funds, insurance companies and other liability driven investors.
Thirdly, the risk profile of credit indices changes through time with passive credit funds meekly following. Although moderating last year, the duration of passive corporate bond funds has successfully tracked index interest rate sensitivity steadily higher over the past decade, a function of lower yields and the move by many corporate issuers to term out debt. If passive credit investors weren’t aware of their heighted exposure to interest rate risk before, they certainly should be after the bloodbath of 2022 in which the £ investment grade credit index was down a whopping 23%. In the same way that the duration of the major indices has changed over time, so too has sector composition and credit quality, with the latter deteriorating markedly over the past few decades. Active managers can, of course, take a view on these respective risks and manage them accordingly.
Today, uncertainty abounds, with the range of probable outcomes regarding inflation wider than it has been in some time and with sell-side analysts almost universally calling for a recession. Should the talking heads prove correct, then default rates will almost certainly pick up. Fundamental credit analysis and stock selection will be more important than ever, but unfortunately your passive credit fund doesn’t employ a manager passionate about doing the hard yards research and due diligence before taking a position. We have also observed increased valuation dispersion within credit markets, creating a fertile hunting ground for active managers to generate alpha, and creating the conditions whereby a high conviction, truly active fund has the potential to deliver very different returns to that of the index. Many of the greatest opportunities and inefficiencies might be in the smaller issues or in off-benchmark positions which the behemoth trackers will have either very limited or zero exposure to. We are currently able to identify several nimble, active credit funds with talented, experienced managers at the helm, who have created highly differentiated portfolios which are delivering yield to maturities significantly higher than that of their respective benchmarks.
The structure and inefficiencies of the bond market have long argued for an active approach in fixed income, with the empirical performance data supporting this contention. This is especially true now bearing in mind both the risks and opportunities that exist in credit markets today.
Ben Mackie – Fund Manager
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