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Finance

Fixed income investing: the active advantage

Active fixed income strategies may offer investors numerous advantages over passive index strategies, providing enhanced risk-adjusted performance potential.

As the U.S. Federal Reserve (Fed) continues to raise interest rates and unwind its balance sheet, investors are re-evaluating their fixed income investment allocations. They still seek returns in this relatively lower yield, low-inflation environment, yet many have made a move to passive investing.

We believe active management for fixed income can better help investors realize their goals. The advantages become more significant as we consider the flawed nature of issuance-based fixed income indexes and the long-standing segmentation of indexed markets.

Active management can be used in any environment

We believe actively managed bond strategies can help manage portfolio risk while enhancing returns. Active sector rotation, bottom-up security selection and interest rate (duration) management can create opportunities for investors to add value that are simply not available in passively managed strategies.

It might be logical to assume that index mutual funds or index exchange-traded funds (ETFs) would match the risk and return characteristics of their benchmarks, but on average these products have exhibited lower returns and higher volatility as shown in Exhibit 1. On the other hand, actively managed mutual funds have historically outperformed their benchmarks while maintaining a similar risk profile, on average.

The return profile of active versus passive is even more pronounced when considering only those mutual funds with fees in the bottom half of the universe — which are the lower-cost share classes many investors own today.

Why is it difficult for index funds to keep up?

Fixed income index strategies may often have difficulty matching their benchmarks' performance due to the complexities of bond indexes. The global fixed income market is nearly 50 percent larger than the global stock market.[1] The most common stock market index, the S&P 500® Index, contains approximately 500 liquid stocks. In contrast, the most widely quoted bond index, the Bloomberg Barclays U.S. Aggregate Index (Aggregate Index), contains 10,000+ securities.[2]

It is impossible to buy all of those bonds, so an index manager must use statistical analysis and sampling in an attempt to replicate the characteristics and performance of the benchmark using fewer securities. And the gross return must outperform the benchmark to cover the management fees.

How can active managers add value?

The most commonly used benchmark, the Aggregate Index, suffers from many drawbacks that provide active managers with more opportunities to generate excess returns and manage risk. These shortfalls include limited sector exposure, increasing credit risk due to market value weighting and duration that fluctuates with issuance. Active managers may add value to fixed income portfolios by taking advantage of these limitations. Let's look at each in turn:

Expanding the investment universe

By their very nature, bond indexes are exclusionary. For example, the Aggregate Index contains thousands of holdings with a market value of more than $20 trillion.[1] But it essentially excludes non-dollar denominated bonds (non-USD), emerging markets debt, global high yield corporate bonds and senior loans.

The index also has minimal exposure to select securitized sectors, such as asset-backed and commercial mortgage-backed securities and non-agency residential mortgages. Thus, the Aggregate Index overlooks trillions of dollars' worth of bond issues.

In contrast, active managers have the ability to strategically allocate away from potentially lower yielding government bonds. They can often supplement index-eligible bonds with off-benchmark investments that may offer higher yield, greater diversification and less sensitivity to rate increases.

Enhancing risk-adjusted returns

In fixed income indexes, securities are weighted by the market value of the outstanding debt, so the most indebted issuers make up more of the index. To be sure, some of the world's most successful institutions (including the U.S. government) carry large debt loads. But passive investing may increase exposure to issuers with higher leverage, declining credit quality or substantial interest rate risk. Active managers, using rigorous credit research processes, can focus on the most compelling opportunities.

Actively managing interest rate risk

Not only is the typical bond index limited in its sector composition, but the sector weights may also change over time. This means the risk factors are not constant, even for an index strategy.

The U.S. Treasury issued more debt in part to finance growing deficits following the financial crisis, and as a result, Treasury exposure in the Aggregate Index increased massively from 25 percent to 38 percent from 31 Dec 2008 to 30 Jun 2018.[3]

The index's duration has also increased over time due to the higher weighting of Treasuries, along with the increased issuance of long-term corporate debt. Longer duration means the bonds tend to be more sensitive to rising interest rates. Active managers can reduce portfolio sensitivity to changing interest rates in two ways:

1) Manage overall portfolio duration. As rates rise, a portfolio with a shorter duration will generally experience a smaller price decline than one with a longer duration. Portfolio managers can actively lengthen or shorten duration as rates rise and fall throughout the cycle.

2) Position portfolios along the yield curve. Interest rates do not typically rise uniformly along the yield curve. For example, if long-term rates rise more, the yield curve steepens. In this environment, an active manager has the flexibility to emphasize intermediate-term securities.

Active fixed income management offers opportunity

We believe actively managed fixed income strategies will continue to add value going forward. Actively managed portfolios have provided better returns with less risk than passive portfolios. Active managers can adjust their sector allocation, benefit from bottom-up security selection and position portfolios to minimize the impact from rising rates. Together, these levers make active fixed income an attractive management strategy.

[1] Bank of International Settlement.

[2] Data source: Bloomberg, L.P. The Bloomberg Barclays U.S. Aggregate Index contained 9,959 securities with a market capitalization of $20.135 trillion as of 30 Jun 2018.

[3] Barclays Live, Bloomberg, 29 Jun 2018.

Glossary

Bloomberg Barclays Emerging Markets USD Aggregate Index includes USD-denominated debt from emerging markets around the world.

Bloomberg Barclays Global Aggregate ex U.S. Index measures the performance of global bonds excluding the U.S. It includes government, securitized and corporate sectors.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC registered, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities.

Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody's/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year.

Duration measures how long it takes, in years, for an investor to be repaid a bond's price by total cash flows. Generally, for every 1% change in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration.

S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors.

A word on risk

Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. The guarantee provided by the U.S. government to treasury inflation protected securities (TIPS) relates only to the prompt payment of principal and interest and does not remove the market risks of investing in the fund shares. Preferred securities are subordinated to bonds and other debt instruments in a company's capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards.

Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness.

This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.

The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC. Nuveen Asset Management, LLC is a registered investment adviser and affiliate of Nuveen, LLC.

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