How to set your active/passive split for fixed income

Traditional passive or benchmark-relative active approaches may no longer be the most effective way of accessing the asset class.

If yields rise, then these strategies could suffer significant losses. In this article we describe a more flexible approach.

This combines passive exposures, designed to address liability risks, with an unconstrained active approach, which could be better placed to deliver returns in this challenging market environment.

Traditionally, most pension schemes have invested either in passive fixed income funds, or in active funds that seek to outperform a gilt, corporate bond or aggregate benchmark – benchmark-relative funds. These approaches have several shortcomings.

First, schemes might invest in bonds to diversify away from growth assets such as equities, but bonds and equities can fall in value at the same time. This happened in 1994 when a sharp rise in the interest rate set by the US Federal Reserve was partly responsible for large losses in both bond and equity markets.

UK equities lost 5.9 per cent, and gilts lost 11.3 per cent over the year. Passive or benchmark-relative strategies will be particularly vulnerable to falling bond markets, given the historically very low level of yields across most markets.

Active v passive

Also, schemes might invest in fixed income as a source of excess returns. But benchmark-relative strategies may not be the best approach.

Bond benchmarks are partly determined by who issues the most debt. This means, for example, that aggregate benchmarks hold more government debt now than before the credit crisis.

This feature will be most evident in a passive portfolio, but it is also likely to be a feature of active funds that use the benchmark as a starting point.

Debt issuance is not necessarily a sign of weakness. However, weighting a portfolio based on the size of debt under issue does not represent an objective investment decision.

Corporate bond returns are also asymmetric. When a company is solvent, investors earn a steady income – albeit with price fluctuations – but losses are substantial if the company defaults.

A fixed income investor constrained by an index may hold companies with significant downside risk. With more freedom they might have excluded these companies from their portfolio.

Finally, schemes may invest in fixed income to offset liability risks. However, most bond portfolios bear little resemblance to a scheme’s liabilities. Durations are usually too short and inflation exposures too low. Passive or benchmark-relative funds are a blunt instrument for controlling interest rate and inflation risk.

Rather than investing in a benchmark-relative fixed income fund, trustees could invest in an unconstrained fixed income fund, possibly alongside a liability-driven investment strategy.

Unconstrained active managers are free to seek out pockets of value across a range of fixed income markets. This type of fund might contain domestic, global and emerging market debt, as well as high-yield debt and some currency positions.

The unconstrained fund could be a Libor-plus type strategy, measured against a neutral benchmark such as cash. Alternatively, it may be measured against a more traditional benchmark, but give the fund manager freedom to invest away from the benchmark.

Tracking liabilities

LDI strategies enable schemes to fine-tune the amount of interest rate and inflation exposure to a greater extent than physical bonds.

They also allow trustees to choose which liability risks to protect against. For example, inflation risk can be hedged in isolation.

Furthermore, LDI only requires a small allocation to assets to achieve the same liability risk protection as a bond fund. Therefore, it can sit alongside an unconstrained bond fund as part of a more flexible and targeted strategy.

Passive or benchmark-relative active approaches may no longer be the most effective way to invest in fixed income.

The strategy described here is more flexible and more targeted to a scheme’s objectives. The passive element can more efficiently address liability risks that the trustees wish to target.

The active element is not tied to an inefficient fixed income benchmark and gives the fund manager the freedom required to generate returns in a difficult market environment.

Jonathan Smith is a UK strategic solutions strategist at Schroders