Is there any value in actively managing bond investments? After all, with all those ETFs and bond mutual funds out there, many that reflect an index, why bother paying someone to manage a fund?
The truth is there are several reasons why active management is a good idea, and with increasing interest rates coming down the pike, bond investments are going to have a lot more value if actively managed than not.
A whole lot of active shorter term, intermediate-term bond investment grade and national muni bond funds have done very well, and done will consistently, when compared to the (passive) index benchmarks. That’s over 1, 3, and 5 year periods.
You need to consider five important issues when it comes to deciding between active bond management and passive bond management.
Aggregate funds? Don’t be so sure
Most investors know about the famous Barclays Aggregate Bond Index. What they don’t know is that the index doesn’t actually have exposure to all kinds of bonds. In truth, it only holds three types of bonds. There are US Government Bonds, US Investment-Grade Credit, and US Securtized securities.
There are six other categories of bonds that the index does not cover – US TIPS, Investment Grade Corporate Debt, Hybrid and Floating Rate Securities, High Yield Bonds, Bank Loans, and Emerging Market Bonds denominated in US dollars.
So the Barclays Index is not, in fact, diversified. If you want to choose other categories to add, then by definition you are now actively managing your own portfolio! So if you’ve gone with the passively-managed Barclays Index, you are not getting full diversification, and if you choose beyond that, you are now actively managing something you may not know much about.
Inefficiency in the Bond Market
I have news for you. The stock market is relatively efficient. The bond markets, however, are not. This is particularly true of muni bonds. Those markets are fragmented, localized, and could pose liquidity concerns. We learned during the financial crisis that you’d better be invested in liquid securities or you could get stuck holding a terrible investment you can’t get out of.
These same fragmentation and liquidity issues are also applicable to the corporate bond market as well, especially the high-yield bond sector. In periods of volatility, some municipal ETFs could trade differently from the municipal bond index.
That’s yet another reason to consider active management for the bond portfolio. Managers who live and breathe the space can likely make better, more liquid, choices than you can.
Interest Rate Effects
The Barclays Aggregate Index holds a pretty large stake in bonds that are sensitive to interest rate movements, thanks to their low coupon and longer maturity terms. Higher rates are coming down the pike. Do you want to be in a passively managed index with this kind of exposure?
An active manager, however, can move and adjust the course of your fund. They aren’t just reacting to interest rates, but also try to outperform the bond market’s returns through analysis of bond prices in relation to creditworthiness.
Next time I’ll look at problems with bond indices and benchmarks.
About Lawrence Meyers – Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]