Bond investors should think twice about passive bond investing

Now more than ever, bond investors need to pay close attention to their asset allocation and how it is performing. Inflation-adjusted real Treasury yields are over 2%, which is a very attractive historical level, and high-quality investment-grade bonds are offering even higher yields.

Fixed income, as an asset class, is currently competitive with other asset classes, something we haven’t seen in decades due to central bank policy rates being so low for so many years, but unfortunately, in my conversations with investors and advisors, I hear that fixed income allocations are still undervalued.

This is likely due to the experience of the past decade, where investors have seen little return from fixed income and, as a result, limited the ability to add value through active management.To be clear, I do not think the current neglect is the fault of investors. do not have Fixed income allocation. The discussion is happening. See my recent article. Forbes An article discussing why investors should walk, not run, into bonds.

My concern is that within that allocation, investors are choosing strategies that may not be best for their objectives. Specifically, many investors are now choosing to accept exposure to broad bond index markets to fill their bond allocations.

What about a traditional 60/40 portfolio allocation?

In a traditional 60/40 portfolio, in most cases, 40% of the portfolio would be better served by taking a more active approach.The main advantage of an active approach to fixed income investing is that it allows for better alignment of an investor’s objectives and risks with their fixed income portfolio.

Without a doubt, the rise of bond index mutual funds and ETFs has been remarkable. The largest bond mutual funds by assets under management are: Bloomberg The largest bond ETF is the Vanguard Total Bond Market II Index Fund, with more than $287 billion as of May 31. The largest bond ETF is the iShares Core US Aggregate Bond ETF, with $110 billion as of June 30. Both are passive funds that aim to replicate the market average return. Bloomberg U.S. Aggregate Bond Index.

Investors have more choices than ever before in how they want to achieve their fixed income investments. Mutual fund and ETF providers offer a vast array of fixed income indexes, and investors should take the time to research before investing. It is important to fully understand the risks and characteristics of the underlying index and remember that indexes change over time. After conducting proper due diligence, investors may find that the underlying index may not align with their investment objectives or risk tolerance. Familiarize yourself with the index.

Sector Allocation: What You Need to Know Bloomberg Aggregate Bond Index

of Bloomberg The Aggregate Bond Index is the broadest and largest domestically taxed investment grade index. As of the end of June, the index included over 13,000 individual bonds with a market value of over $27 trillion, including U.S. Treasury bonds, U.S. government-related obligations, mortgage-backed securities (MBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS).

In my experience, individual and institutional investors rely on this index to describe the domestic bond market, but just because it is the largest and most comprehensive domestic taxable bond market index does not mean it is the right investment indicator for all investors.

Looking at the basic characteristics of the index, we see that the sector composition is 48% Treasury and government bonds, 24% corporate bonds, 26% MBS, and a mix of ABS and CMBS at 2%.

Investors in passive mutual funds and ETFs tracking this index should be aware that over 48% of their investments are in U.S. Treasury and government-related securities, and this amount is likely to increase significantly. The Congressional Budget Office projects that the amount of federal debt will increase from 99% of GDP in 2024 to 122% in 2034. These investors should question whether this allocation is appropriate for their particular needs, and whether they are simply investing blindly because it gives them broad market exposure.

Duration: Another important fixed income risk characteristic

In addition to sector allocation, another very important bond risk characteristic is duration. Duration is a measure of interest rate risk, and the longer a bond or portfolio’s duration, the more interest rate sensitive it is. Passive bond index investors should not only know the duration of the underlying index, but also pay attention to how this risk measure changes over time. For example, investors seeking tax-exempt income through passive municipal bond funds or ETFs should Bloomberg Investors in muni bond indexes need to understand the duration of the index and how it changes over time. The same is true for taxable investors in funds or ETFs that benchmark to muni bond indexes. Bloomberg Corporate bond index.

Passive funds typically charge lower fees than active funds and separately managed accounts, which raises the question of whether active managers who charge higher fees can outperform passive funds on an after-fee basis. Lucifer Over the past decade, active fixed income fund managers have outperformed passive funds by an average of 10 to 40 basis points on a net-of-fees performance basis in the intermediate-term core bond and corporate bond categories. To be fair, there have been years when passive outperformed active, but the data suggests that on average over time active managers are able to justify higher fees.

“Nobody puts fixed income in a corner.”

Active management of bonds comes in many forms, from actively managing allocations among select passive funds to holding individual bonds. While holding individual bonds is my preferred approach when assets are large enough, active allocation can be implemented at nearly any scale. The overall goal, at implementation and on-going, is to match an investor’s specific investment objectives, goals, and risk tolerance with those of a bond portfolio. That being said, I suggest investors take a more active approach to bond investing. “No one puts bonds in a corner!” Don’t ignore bonds. Bonds require caution.