Bonds 103: Comparing Active and Passive Bond Investing Strategies

What are active and passive bond investment strategies?

Passive investment strategies involve buying and holding bonds until maturity or investing in bond funds that track bond indices. Passive approaches may suit investors seeking some of the traditional benefits of bonds such as capital preservation, income, and diversification. However, they do not attempt to capitalize on the interest rate, credit or market environments.

Active investment strategies, by contrast, aim to outperform bond indices, often by buying and selling bonds to take advantage of price movements. To outperform indices successfully over the long term, active investing requires the investor to form opinions on the direction of the economy, interest rates and credit environment, and also to trade efficiently and manage risk.

What passive strategies can an investor use?

There are two main passive strategies available to investors – buy-and-hold and index trackers.

1. Buy-and-hold strategy

   Investors seeking capital preservation, income and/or diversification may simply buy bonds and hold them until they mature. One of the main risks of this strategy is reinvestment risk, that is, the risk the investor may be forced to buy a lower-yielding bond when it comes time to reinvest.

2. Index tracker strategy

   Another option is to use a passive investment strategy that attempts to match the performance of a bond index. Similar to equity indices, bond indices are transparent (the securities in it are known) and performance is updated and published daily.

Many exchange-traded funds (ETFs) and certain bond funds invest in the same or similar securities held in bond indices and thus closely track the performance of the index. In these passive bond strategies, portfolio managers change the composition of their portfolios if and when the corresponding index changes, but they do not generally make independent buy or sell decisions.

What active strategies can an investor use?

Investors who want to outperform bond indices use actively managed investment strategies. Active portfolio managers can attempt to maximize income or capital (price) appreciation from bonds, or both. Many bond mutual funds and a number of ETFs are actively managed.

One of the most widely used active approaches is total return investing, which uses a variety of strategies to maximize capital appreciation. Active bond portfolio managers seeking price appreciation try to buy undervalued bonds, hold them with the anticipation that they will rise in price and then sell them before maturity to realize the profits – ideally "buying low and selling high."

Active managers typically employ a number of different techniques to identify bonds likely to rise in price. These include:

• Credit analysis: "Bottom-up" credit analysis to identify bonds that may rise in price due to an improvement in the credit standing of the bond issuer.
• Macroeconomic analysis: “Top-down” analysis to find bonds that may rise in price as a result of economic conditions, a favorable interest rate environment, or global growth patterns.
• Sector rotation: Investing in sectors that have historically increased in price during a particular phase in the economic cycle and avoiding those that have underperformed at that point.
• Market analysis: Buying and selling bonds to take advantage of changes in the supply and demand dynamics that cause price movements.
• Duration management: Adjusting the duration of a bond portfolio to manage interest rate risk. For example, shortening duration to help mitigate the effects of a rise in rates.
• Yield curve positioning: Adjusting the maturity structure of a bond portfolio based on expected changes in the relationship between bonds of different maturities.
• Roll down: When short-term rates are lower than longer-term rates, a bond is valued at successively lower yieldsand higher prices as it approaches maturity or "rolls down the " A bond manager can hold a bond for a period of time as it appreciates in price and sell it before maturity to realize the gain.
• Derivatives: Active managers can use futures, options or other derivatives to express a wide range of views, from the creditworthiness of an issuer to the direction of interest rates.
• Risk management An active bond manager may also take steps to maximize income without increasing risk significantly, perhaps by investing in some longer-term or slightly lower-rated bonds that carry higher coupons.

Why choose an active bond strategy versus a passive bond strategy?

There has been much discussion about active and passive investing in recent years as investors assess the value of professional investment management. While much of the focus has been on the equities market, the question of active versus passive is also an important question when it comes to bonds.

A major point of contention in this debate is whether the bond market is too efficient to allow active managers to consistently outperform the market.

An active bond manager, such as PIMCO, would counter this argument by noting that both size and flexibility enable active managers to take advantage of short- and long-term trends in their efforts to outperform the market.

Active managers also manage interest rate, credit and other potential risks in a bond portfolio in an effort to generate investment returns.

Actively managed investments tend to charge higher fees than passive investments, and there is the possibility that performance will fall short of the market. However, studies of long-term performance have shown that active bond mutual funds and ETFs – unlike their equity counterparts – have largely outperformed their passive peers after fees.

The chart below shows the performance of the median active and passive U.S. managers in the 10 years to 31 December 2023, in the largest bond and equity category tracked by Morningstar. You can see from the chart that the median active bond manager outperformed their passive counterparts and the benchmark. The same cannot be said for equities, however, with the median active equity manager underperforming the benchmark and the median passive manager.