After a turbulent two years (2022 and 2023), bonds are looking to have a comeback as the Fed signalled we have likely reached peak rates after experiencing one of the most aggressive rate hike cycles since the 1970s.
The Bloomberg Global Aggregate Bond Index returned 7% in 2023 (in USD terms), and some expect the asset class will continue to be attractive going into 2024 and 2025, from both a high cash yield and potential total return perspective, especially if the Fed indeed starts cutting rates in 2024. (Note: bond prices and yields have an inverse relationship, when interest rates go down, bond prices will rally and vice versa.)
While it’s established that passive investing has a place in individuals’ stock portfolios (even endorsed by Warren Buffett), what about bonds? Should you turn to passive bond ETFs as a convenient choice to get exposure to the fixed income markets?
It might come as a surprise to some, unlike the world of equity investing, there are structural differences in the bond markets, which makes it challenging for investors to enjoy the same benefits of passive investing in the fixed income space.
Why passive investing does not work as well for bonds
1) Much larger size and complexity of the global bond market
There are ~344,000 securities in the bond market compared to ~14,400 in the stock market for the representative global index. Due to the size and complexity of the bond market, passive ETFs invest in an optimised sample of bond securities instead of a full replication, as the underlying benchmark is not practical or cost-effective.
For example, the Bloomberg US Aggregate Bond Index includes more than 10,054 securities, while the leading ETFs that track the index include only ~29-73% of those securities. Passive fixed income ETFs are actually making active decisions daily to choose who to replicate its benchmarks.
2) “Buying more of the worst”
Just like in equities, bond indexes are typically market capitalization-weighted using the outstanding market value of bonds. This makes sense in equities where large index-weighted companies also tend to also be the largest and most successful companies.
However, in bond indexes, this means companies with the highest amount of debt outstanding would have a higher weighting. This means you are holding more of a company's debt as it becomes more leveraged - it's essentially “buying more of the worst”.
3) Finite life of bonds
Bonds have a maturity date, which means that there will constantly be bonds maturing and new issues launched, as compared to the perpetual nature of stocks.
As a result, bond indexes are reconstituted more often which creates higher transaction costs.
4) Illiquidity
Parts of the bond market are illiquid and may not trade for days or even months. Smaller bond issues may not have an active secondary market. Bonds also become more illiquid as they approach maturity. This again leads to higher transaction costs and makes it much more difficult for bond ETFs to be able to replicate their tracking indices.
5) Lag in credit ratings
Bond indices use official credit ratings from rating agencies such as S&P, Moody's and Fitch, to categorise bonds in sub-asset classes (i.e. AAA, AA, BBB, etc, investment grade or high yield).
There is often a lag in the rating agency's upgrade or downgrade of a bond versus the underlying issuer's change in credit fundamentals, whereas the market is well-ahead in pricing it in. This means that the passive index fund will buy or sell bonds late in the game.
The case of active management for bonds
Industry research has focused on the argument for passive over active in the equities space. Not much discussion has revolved around the fixed income space.
Bond ETFs have democratised access to an asset class that was previously hard for the average investor to invest in, but there are inherent structural challenges in passive bond investing.
Passive funds for many fixed income categories have consistently wider tracking error and underperformance versus their respective benchmarks, especially when compared to passive equity funds or ETFs.
Based on research by Morningstar, over a 10-year period, active bond fund managers are 5x more likely than equity fund managers to be able to beat benchmark returns. Learn more about why this is the case with this article here.
Read more: Passive investing for stocks, but how about bonds?
Accessing Best-In-Class fixed income funds through Endowus
Endowus Hong Kong offers a diverse range of Best-In-Class fixed income active funds managed by world-class bond managers such as AllianceBernstein, JP Morgan Asset Management, and PIMCO.
Here are some selected fixed income funds on the Endowus Fund Smart platform, you can also access the full list here.
Spotlight on fixed income funds
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