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Bond Market Complexity: The Case for Active Management Thumbnail

Bond Market Complexity: The Case for Active Management

Investing

Evidence-Based Investing (EBI) isn't just a principle that's strictly for equities. In the nuanced world of bonds, EBI shines a light on many of the inherent challenges and risks – guiding investors toward more informed decisions.

Evidence-Based Insights on Bonds

When Eugene Fama and Kenneth French extended their research into the bond universe, they pinpointed two significant factors that influence bond returns: term and credit.

  • Term: Historically, bonds with longer maturities have tended to offer higher yields to compensate for the added risks. Yet, the question is always, "Are those added returns worth the increased volatility?"
  • Credit: This refers to the risk associated with bond issuers potentially defaulting on their payments. While higher-yield (or 'junk') bonds can offer tantalizing returns, they come with a catch: increased default risk. Fama and French's analysis suggests investors should be cautious and ensure they're adequately compensated for this risk.

A report by Vanguard found that while investment-grade bonds have historically provided a relatively stable stream of income, high-yield bonds displayed equity-like volatility.3

The Dilemma with Bond Indices

At face value, bond indices might seem like a straightforward way to gain exposure to the bond market. But there's more beneath the surface:

  • Bias Towards the Heavily Indebted: Bond indices often have a tilt towards the most indebted issuers. As Howard Marks, co-chairman of Oaktree Capital, quipped, "Indexing in the bond market defines investing as lending the most money to those who've borrowed the most".4
  • Static Allocations: Unlike active managers, bond indices can't dynamically adjust their allocations in response to changing market conditions.

This is where evidence-based active managers, armed with the insights of Fama, French, and other researchers, can add significant value.

Active Managers: Navigating the Bond Labyrinth

Active bond managers possess the agility to adjust portfolios based on current market conditions and the evolving risk-return landscape. They are not bound by an index's rigid structure and can thus act when they perceive that certain risks in the bond market aren't being adequately compensated.

In a study by Morningstar, it was found that about half of active bond fund managers have, on average, outperformed their passive counterparts over a 10-year period5, further highlighting the potential advantages of an active approach in the complex bond market. It should be noted that many of the active bond managers are hoping to get a similar return for a reduced level of risk. 

Conclusion

The bond market, with its intricacies and nuances, demands a refined, evidence-based approach. And while the age-old debate between active and passive management continues, in the world of bonds, active management – especially when grounded in robust research – seems to have a compelling edge.

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Sources:

  1. Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of financial economics, 116(1), 1-22.
  2. Berkin, A. L., & Swedroe, L. E. (2016). Your Complete Guide to Factor-Based Investing: The way smart money invests today. BAM ALLIANCE Press.
  3. Vanguard. (2021). Why Bonds Still Matter in a Low-Yield World. https://institutional.vanguard.com/insights-and-research/perspective/why-bonds-still-matter-in-a-low-yield-world.html
  4. Marks, H. (2013). The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor. Columbia University Press.
  5. Morningstar. (2019). Active vs. Passive: The Bond Market Paradox.

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