Why active management matters when it comes to fixed income

17 March 2025 by National Bank Investments

Many investors believe that active managers struggle to outperform or even match their benchmarks. However, this isn’t generally true in fixed income. Bond markets are less efficient and transparent than equity markets, presenting inefficiencies that active managers can capitalize on.

Here are 5 reasons why active management in fixed income matters more than ever:

In this article:

Active vs. passive management performance
Levers to enhance returns and exploit inefficiencies
Volatility as an ally
Avoid the pitfalls of passive investing
Winning by not losing

01 Active vs. passive management performance

According to MercerInsight¹, the median active managers have outperformed benchmarks in global credit and aggregate strategies over the past decade.

The chart illustrates that over 1 year, 3 years, 5 years, 7 years and 10 years, median managers generally outperformed the index.

Source: MercerInsight data as of Q3 2024. This is a customized universe and not an official Mercer universe. Net of fees and hedged into US dollars. Traditional indices used for comparison are Bloomberg Global Aggregate Index (hedged into USD) and Bloomberg Global Credit Index (hedged into USD).

These findings highlight the need to consider more than just yields when selecting bonds. Careful thought needs to be given to manager selection, with a focus on ensuring a robust investment process that provides greater likelihood that excess returns are repeatable.

_¹ MercerInsight. As of September 30, 2024.

02 Levers to enhance returns and exploit inefficiencies

Fixed income managers have several levers at their disposal to add value. To exploit them, you must understand them well, and this requires a level of attention and expertise in the following 7 strategies:

Duration and yield curve: Positioning based on market yield outlooks or yield curve shape.
Security selection: Identifying undervalued securities with strong fundamentals.
New-issue premium: Taking advantage of new debt being issued at above-market yields.
Exploiting market fragmentation: Seeking opportunities arising from the fragmented nature of bond markets.
Sector strategy: Targeting sectors offering the best opportunities or avoiding high-risk sectors.
Beta management: Adjusting credit risk exposure to capitalize on expected credit market trends.
Relative value: Exploiting value differences across markets.

03 Volatility as an ally

Volatility is the friend of active managers. Greater flexibility allows managers to exploit opportunities that arise from volatility, avoid unrewarded risks, and shift to defensive assets when needed. Bonds are frequently misvalued during periods of volatility, and sharp market moves can become big opportunities for active managers with robust investment processes returns by avoiding credit deterioration and focusing on strong fundamentals and diversity.

Chart illustrates that the bond market volatility has been elevated in the last 3-4 years after a decade of low volatility.

Source: Insight and Bloomberg. Data as of December 31, 2024.

04 Avoid the pitfalls of passive investing

Investors should be aware of the limitations of traditional fixed income indices, which are biased towards the most indebted entities. The high presence of BBB-rated corporates increases downgrade risks during economic stress, potentially resulting in forced sales at inopportune times.

The chart shows that the percentage of BBB-rated companies has increased compared to AAA- and AA-rated companies.

Source: Insight and Bloomberg. Data as of December 31, 2024.

05 Winning by not losing

Not all investors seek to maximize returns – some prioritize safe, reliable cashflows. Active managers can enhance returns by avoiding defaults and credit deterioration, focusing on strong fundamentals and diversified portfolios. For investors seeking safe and predictable cash flow, active managers can enhance returns by avoiding defaults and credit deterioration and reducing these six risks:

Liquidity risk: the likelihood that a company will not be able to meet its obligations to pay interest on outstanding debt and repay the principal at maturity.
Regulation and litigation risk: regulatory risk varies significantly by sector. Industries with stringent regulatory oversight, such as utilities, may face profitability caps or mandatory capital expenditure requirements.
ESG risk: how Environmental, Social, and Governance (ESG) factors may impact a company's financial stability.
Climate risk: exposure to physical climate risks or transition risks due to climate change, whether through its location, product range, or supply chain.
Event risk: the possibility of the company undergoing mergers and acquisitions (M&A), either acquiring another company or being acquired itself, which could substantially affect its debt obligations.
Leveraged buyout risk: the company's susceptibility to a leveraged buyout (LBO) by private equity, which can result in increased debt on the balance sheet.

Active portfolio managers can improve fixed income returns through various strategies like managing duration, yield curves, security selection, new-issue premiums, market fragmentation, and sector strategies. They can enhance portfolios by managing credit beta and finding relative-value opportunities. These methods, if executed well, can boost performance whether aiming for higher returns or stable cash flow.

This article is based on the Insight Investment research document: Enhancing Fixed Income Markets - The Power of Active Investing.

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