Don’t put your bonds on autopilot in 2016

Douglas Peebles, CIO and head of Fixed income at AB warns that investors should pay close attention to the performance of bonds in their portfolio. 

The bond market is probably in for more turbulence in 2016, and investors may have to make some course corrections along the way. Staying airborne in these blustery conditions requires an active strategy.

It can be tempting to opt for passive index strategies in fixed income. Some of these strategies have performed reasonably well recently. But over a longer time horizon, passive fixed-income strategies have generally underperformed active ones. And while many passive strategies are inexpensive, that’s not necessarily true in every fixed-income sector.

Global bond markets are becoming more unpredictable. Investors will face a number of headwinds this year, including rising US interest rates, slower growth in China and other emerging economies, and a likely rise in corporate defaults. We doubt passive strategies will be up to these challenges.

Lending to the Biggest Debtors

To understand why a hands-on approach is best in fixed income, let’s take a look at how bond indices work. Most are weighted according to issuance. That means companies and countries that borrow often are the index’s biggest constituents.

In other words, when you buy a passive strategy that tracks a bond index, you’re lending money to the biggest debtors, which isn’t always desirable. High debt levels—for a country or a company—can be a sign of trouble. A default—or even a ratings downgrade—could mean large losses for index investors.

More Levers to Pull

The more levers a manager has to pull, the easier it is to avoid these and other passive pitfalls. Instead of being locked into an index, a skilled manager can pick and choose among a wide array of securities and avoid those that seem to offer more risk than reward.

Managers can also combine exposure to safer assets, such as government bonds, and riskier ones such as high-yield corporates. These combinations are usually negatively correlated, meaning one does well when the other does poorly. Managers can tilt one way or the other depending on prevailing market conditions.

Here’s a sector-by-sector look at how we think a hands-on approach can help:

1) Sovereign Debt: It’s a major component in core bond portfolios, which investors rely on to provide stability, income and diversification against equities. Here’s the problem: if your core bond strategy is passive, you’re not just exposed to the biggest debtors—you’re taking on a lot of currency risk, too. For example, if you’re tied to an index, you’re heavily exposed to Japanese government bonds, one of the biggest weights in the index. Since these are priced in yen, you’re also exposed to the currency. Exchange rates tend to be volatile, and unhedged currency exposure can undermine returns. An actively managed global portfolio can strip out the currency risk, which our research has shown leads to better risk-adjusted returns.

2) Investment-Grade Corporates: The companies that issue these bonds have relatively strong finances and are unlikely to default suddenly. But they are subject to ratings downgrades when their credit profiles weaken. And downgrades can be costly, especially when they involve “fallen angels”—investment-grade issuers that tumble into junk territory. Through November, $140 billion of bonds fell from investment grade to junk (Display). With global growth slowing, it’s more important than ever to pick and choose your bonds carefully.

3) High-Yield Bonds: In this market, the credit quality of issuers varies widely. A passive approach means you can’t avoid companies with fragile credit profiles and a relatively high risk of default. Some investors learned that the hard way last year when the decline in oil prices battered energy company debt—the biggest component of major high-yield indices—and pushed some companies into default. Passive high-yield strategies have consistently underperformed active ones over a longer time horizon, too.

4) Emerging-Market (EM) Debt: Decades ago, there was very little to distinguish one EM bond from another. The issuers had all defaulted in recent memory and their debt traded at a high spread relative to US Treasuries. Those days are gone. Bonds issued by Venezuela might trade at a 20% spread, while Mexican bonds trade near 3%. This is the result of vast policy differences. Mexico has embraced economic reform and diversified its economy; Venezuela hasn’t. Exploiting these differences requires an active approach.

It’s important to remember that if you’re tracking an index, you’re locked in. You get exposure to every name in the index, whether you want it or not, and you get the most exposure to the biggest debtors. To us, that doesn’t sound like a winning formula.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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