The decade long bull market has made a strong case for passive investing in equities, and some of this sentiment has convinced many fixed income investors to do the same. But the arguments for passive equity investing don’t fly for passive fixed income investing. As economic growth slows in the U.S. and around the world, it may be signaling the end of the current credit cycle, which may increase risk for passive fixed income investors. A better choice may be to consider nimble and flexible active managers who offer a more selective approach offering greater defense against economic recession.

Diminishing credit quality

Many investors consider the BarCap Aggregate to be the bond world’s analogue to the S&P 500®. But this is a foolish assumption. The only thing they have in common is that they’re comprised of securities issued by larger companies. Their risk characteristics are quite different.

Weightings in the S&P 500® rise and fall with the market capitalization of the companies that comprise the index. Conversely, weightings in the BarCap Aggregate reflect the total outstanding debt each company issues, subject to the index’s credit quality standards.

Here’s the problem. In recent years, many lower-rated companies in the index have taken on more debt, which is giving these companies higher weightings in the index.

The chart above shows that a hypothetical buyer of the index would historically have received less compensation for holding riskier credits.

Currently, option-adjusted spreads for the BarCap Aggregate are hovering around 75% of its 10-year average. During this time, the weightings of BBB-rated issues have risen by almost 20% and now constitute more than 50% of the index’s investment-grade debt.

This increasing credit risk reduces the overall credit quality of passive fixed income investors. For passive fixed income investors, following  index methodology means they must take on the added debt of constituent companies, even if their underlying fundamentals are weakening.

Looking for yield premiums

An uncertain fixed income market favors managers who can be nimble and selective and focus on finding yield premiums and higher credit quality outside the larger issuer universe. For example, right now, bonds from highly rated (A to A-) smaller issuers offer a yield premium ranging from 9 to 41 basis points higher than their larger counterparts, as shown in the chart below.

Historical yield premiums of large vs small issuers

Some of this yield premium reflects the overall lack of market efficiency in the small end of the market. With mainstream investors favoring larger issuers, bonds from smaller companies are often undervalued, providing open-minded fixed income investors with opportunities to selectively exploit these  opportunities.

Other yield premiums may be found among private placements. These fixed income issues, authorized by SEC Rule 144a, are generally only traded by qualified institutional investors and offer the benefit of shorter holding periods that range from six months to a year, compared to two years for other kinds of private placements.

Why smaller and nimbler is better

Among active fixed income managers, those who constrain their assets at a relatively lower level have certain advantages compared to the larger managers in the universe. They’re not pressured to hold hundreds or thousands of positions to keep the portfolio fully invested. They can identify yield premiums by using technical analysis to identify dislocation and mispricing opportunities within sectors or among individual securities. Their mandates often allow them to take advantage of yield premiums offered by private placements and other alternative investments. And when recessions occur, their smaller portfolios enable them to exit positions more efficiently and thoughtfully than larger firms that must quickly make hundreds of trading decisions to generate liquidity to accommodate outflows.

When the economy is on a roll, and markets are rising, investing in passive and active index-huggers often seems like a no-brainer. But when warning signs like weakening fundamentals and declining credit quality rear their ugly heads, prudent fixed income investors may be better off shifting some of their assets to smaller managers who may be better prepared to weather the approaching storm.

About Securian Asset Management

Securian Asset Management, Inc. based in St. Paul, MN, is an institutional asset manager specializing in public and private fixed income, commercial real estate debt and equity, pension solutions and alternative investments strategies with more than $42 billion under management as of June, 2019. The asset manager was established in 1984 and traces its history to the founding of parent firm Securian Financial Group in 1880.

The author of this article, Dan Henken, CFA and Vice President of Securian Asset Management, has 16 years of investment management experience.

For more information on Securian Asset Management’s fixed income strategies, please contact the Securian Asset Management team at 1-800-665-6005.