Passive management of various asset classes is well documented both in theory and in practice and it has some clear advantages. This is why many investors, advisers and journalists assume that the same must be true for the asset class Fixed Income. However, bonds are different. We are convinced that passive management of this asset class has, by definition, serious disadvantages that can only be overcome by an active management approach. Passive management of fixed income securities leads to unsatisfying results. There is no compensation for significant risks, or attractive returns are foregone because of the existing risk.
Bond indices and benchmarks have the following serious structural disadvantages:
Example: Interest rate risk
Increasingly long duration of bond indices in a context of increasingly low interest rates. For instance, the duration of the Swiss Bond Index SBI, a widely used benchmark for fixed income securities in the Swiss market, has risen from 5.0 to over 7.5 over the past ten years – an automatism that increases risk in case of decreasing returns.
Example: Credit risk
Too much exposure to vulnerable issuers whose debt is high or steadily increasing, be it countries, sectors or individual companies. Thus, in a broad reference index for fixed income securities in EUR, Italy with its significant debt is a heavyweight. At the end of the 20th century, the telecommunications sector took on massive debt to finance 3G licenses and its weight in bond indices increased considerably – automatisms that increase exposure in case of deterioration in quality.
Structural deterioration and recovery of the financial industry (a very important sector in any bond index) since the financial crisis, or the massive changes in profitability and vulnerability of the energy sector with every major change in oil prices – automatisms that take precedence over portfolio management in the event of external trends, structural disruptions or shocks.
Yield and spread levels are not taken into account, despite the fact that the attractiveness of an investment also depends on its price. However, even minimal or even negative yields or extremely low credit risk premiums are systematically and automatically bought.
Late and forced sales at the rating threshold after a downgrade, “Rising Stars” or “Fallen Angels” cannot be bought at all. The rating agencies focus even more on accounting information, which changes only slowly and is often subject to “window dressing” – automatisms that almost always lag behind market and price information, which reacts more quickly.
Defining a benchmark makes sense, but the benchmark should primarily be used to define the overall risk target in terms of interest rates and credit quality.
Beyond that, the benchmark structure is irrelevant, and the portfolio should deviate significantly from it - precisely to avoid the disadvantages referred to above.
Active fixed income management allows for the construction of defensive, stable and broadly diversified portfolios with higher yields and significantly better risk-adjusted returns over the long term.