Avoiding concentration risk
Earlier in 2022, FTAdviser interviewed Artemis fixed income manager Stephen Baines, who acknowledged the rising popularity of passive bond strategies.
There have been significant inflows of money in recent years into passive funds such as exchange-traded funds that track bond indices, as investors have sought ways to get exposure to credit without paying active fees or as a way to play the market through higher-frequency trading.
But Baines explained these strategies can work against the investor, causing them to end up with a fund that has a high concentration of risk, higher trading costs and a significant deviation from the performance of the underlying bond index.
Portfolio construction means passive funds do not track all the bonds within a given market. For example, while there are more than 2,000 bonds in the US high-yield bond market, the largest ETF holds just 1,321. The sampling error by which companies are chosen to be in that passive fund, the ETF or tracker, is automatically skewed towards the most indebted issuers, which could pose enormous risks.
Income generation
According to Kleinwort Hambros' chief investment officer Fahad Kamal, active management also helps to boost income.
He says: "Income (coupons) is of paramount importance, especially in an environment of low and stable yields. Bond returns were boosted by a secular wave of multi-decade, ever-lower yields that probably came to an end in 2020.
"In a highly volatile rates environment, active management can provide incremental returns over passive strategies, for example by adjusting duration, yield curve positioning, sector and issuer selection."
Exploiting carry trades
Fund managers can occasionally deploy carry trades to make a return for investors.
Carry trades involve borrowing at a low interest rate and investing in an asset that provides a higher rate of return.
For example, a manager might want to benefit from currency movements, so would borrow a low-interest rate currency and convert the borrowed amount into another currency by buying the bonds of that country.
McEachern explains: "For short-dated bonds, carry (which represents the interest income in excess of the risk-free rate) is a source of return.
"In a yield rising environment, investors can take advantage of higher-yielding assets as existing holdings mature and new issuances are released at higher yields."
He adds: "Carry helps to offset bond prices fall. As prices have dropped the carry has risen and is now much higher than it was at the start of the year. "
Investors should ask what are the implications of this? McEarchern continues: "Looking exclusively at the carry element, if we were to see similar interest rate rises and spread widening as seen over the past five months, this will more likely result in the bonds not incurring losses.
"The first half of this year has been particularly painful, because we started with low carry, a negative yielding market, and no protection, followed by a sharp price decline.
