Fixed Income Investors Should Think Twice About Passive Bond Investing

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Now more than ever, bond investors need to pay attention to their allocation and how it is being managed. Real Treasury bond yields, after adjusting for inflation, are above 2%—a level that, historically, has been very attractive. The yields on high-quality investment grade bonds are even higher.

Bonds, as an asset class, are now competitive with other asset classes, a situation we have not experienced in decades due to years of very low central bank policy rates. But sadly, in my conversations with investors and advisors, their bond allocation is still being neglected.

Perhaps this is due to experiences from the past decade, where investors earned very little on bonds and, as a result, the ability to add value through active management was limited. To be clear, I do not think the current neglect is due to investors not allocating to bonds. Those conversations are happening—see my recent Forbes article discussing why investors should walk, not run, into bonds.

The concern I have is, within that allocation, investors are choosing a strategy that may not be the best investment for their objectives. Specifically, many investors are now choosing to accept broad bond index market exposure to fill their bond allocation.

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What About The Traditional 60/40 Portfolio Allocation?

In the traditional 60/40 portfolio, 40% of the portfolio would be better served, in most cases, by taking a more active approach. The primary advantage of an active approach to bond investing is that it can better align the objectives and risks of the investor to their bond portfolio.

No doubt, the rise of bond index mutual funds and ETFs has been impressive. The largest bond mutual fund in terms of assets under management, according to Bloomberg data, is the Vanguard Total Bond Market II Index Fund, at more than $287 billion as of May 31. The largest bond ETF is the iShares Core U.S. Aggregate Bond ETF at $110 billion as of June 30. Both are passive funds that seek to replicate the return of the Bloomberg U.S. Aggregate Bond Index.

Investors have more choices now than ever as to how they want to accomplish their bond investments. Mutual fund and ETF providers offer a plethora of bond indexes, and investors need to take the time to research before investing. It’s important to have a thorough understanding of the risks and characteristics of the underlying index—and to remember that indexes change over time. After conducting the proper due diligence, investors might find the underlying index does not line up with their investment objectives and risk tolerances—know your index.

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Sector Allocation: What To Know About The Bloomberg Aggregate Bond Index

The Bloomberg Aggregate Bond Index is the broadest, largest domestic taxable investment grade index. As of the end of June, that index contained more than 13,000 individual bonds with a market value of more than $27 trillion, and it includes U.S. Treasuries, U.S. government-related bonds, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities.

From my experience, retail and institutional bond investors have gravitated to this index as their go-to when describing the domestic bond market. But just because it is the largest, most inclusive domestic taxable bond market index does not mean that it is a suitable investment proxy for all investors.

The underlying characteristics of this index show that the sector weighting consists of 48% U.S. Treasuries and government bonds, 24% corporate bonds, 26% MBS and 2% combined ABS and CMBS.

Investors in passive mutual funds and ETFs that track this index should realize that more than 48% of their investment is in U.S. Treasury and government-related securities—and that this amount will likely move significantly higher. The Congressional Budget Office estimates that the amount of federal debt will increase from a projected 99% of GDP for 2024 to 122% in 2034. These investors should question whether this allocation is appropriate for their specific needs and not just blindly invested because it gives them broad market exposure.

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Duration Is Another Key Fixed Income Risk Characteristic

Duration is a measure of interest rate risk—the higher the duration of a bond or portfolio, the higher the interest rate sensitivity. Passive bond index investors should not only know the duration of the underlying index, but also be aware of how this risk measure changes over time. As an example, investors seeking tax-exempt income through passive municipal bond funds and ETFs benchmarked against the Bloomberg Municipal Bond Index should understand duration and changes over time for that index. The same goes for taxable investors in funds and ETFs benchmarked against the Bloomberg Corporate Bond Index.

Passive funds typically have a lower fee than active funds or separately managed accounts. So, the question is: can active managers, with their higher fees, outperform the passive funds on a net-of-fee basis? A recent report by Morningstar showed that, over the last 10 years, active bond fund managers have been able to outperform passive funds on an average of 0.1% to 0.4% on a net-of-fee performance basis in the intermediate core bond and corporate bond categories. To be fair, there are years when passive has beaten active, but the data suggests that, over time and on average, active managers can justify their higher fee.

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Don’t Neglect Your Bond Strategy

Active bond management can take on various forms, ranging from actively managing the allocation among select passive funds, to owning the individual bonds and everything in between. Owning individual bonds is my favored approach when the assets are of sufficient size. However, an active allocation can be implemented for almost any size. The overall goal is to match the specific investment objectives, goals and risk tolerance of the investor to that of the bond portfolio upon implementation and on an ongoing basis. That said, I suggest investors take a more active approach to bond investing. Don’t neglect your bonds, they need your attention.