Years of persistent low yields across much of the global fixed income market have spurred many investors to look lower down the credit spectrum in search of yield, or to increase their allocation to equities, in an effort to meet portfolio return objectives. Many of these investors have also been drawn to passive index strategies as a way to capture low-fee exposure to these higher-yielding markets. In an aging expansion, how are these investors positioned to weather potential disruptions or market downturns over the horizon?
For many equity investors, passive strategies have paid off. According to Morningstar, 70%–90% of active equity managers have underperformed their passive peers over the last 10 years. But do we see the same story playing out in bond markets, and higher-yielding credit markets in particular? Investors seem to think so: In the U.S., high yield funds have experienced large inflows so far in 2019, and a significant portion of those assets have gone into passive strategies (such as ETFs), according to Morningstar.
These investors may be utilizing passive funds as a less expensive way to access high yield market beta, but the fee savings may be less than they expect,1 and the trade-offs may be painful: In the 12 years since Morningstar began tracking the passive fund category, during weak market periods, passive high yield funds have underperformed actively managed high yield funds.2 And looking at quarterly returns across all market periods over the same 12-year time frame, active high yield strategies modestly outperformed passive strategies. Given the inherent uncertainties in lower-quality sectors such as high yield, portfolios should be prepared for market volatility and shocks as well as the credit risks of individual issuers.
Put simply, passive may work well for equities, but our research shows bonds are different - including in high yield markets.
Active, passive, and benchmark data for high yield
Particularly in high yield market downturns, the data suggest active management makes a difference. We looked at monthly returns of active and passive U.S. ETF and mutual funds for 143 periods from May 2007 – March 2019 (source: Morningstar). In the 45 periods (individual months) when the ICE BofAML High Yield Constrained Index experienced negative returns, active high yield funds outperformed passive high yield funds 62% of the time and by an average of 80 basis points (bps) – see Figure 1. And across all market periods (downturns, stable, and rising markets) over that past 12 years, active high yield strategies outperformed passive strategies by 17 bps on a quarterly basis.
Active high yield may outperform passive especially in weak markets, but how do both approaches fare against the benchmark over time?
During periods of positive market returns, high yield benchmarks tend to be difficult to beat, in part because they are difficult to track closely. As explained in our 2017 quantitative research report, “Bonds Are Different: Active Versus Passive Management in 12 Points,” high yield index performance is difficult to mimic due to lower liquidity of the market and high transaction costs. One reason for that is 32% of high yield issuers have debt of less than $500 million (according to Bank of America, as of March 2019), which makes their bonds less likely to be available for sale and more likely to come with high transaction costs.
But active managers with more robust risk management capabilities and expertise in credit research and analysis can outshine other peers. For example, over the 10-year period ending June 2019, active managers underperformed the BofAML High Yield Constrained Index by 1.1% on an annualized basis, and passive managers underperformed the same index by 1.6%. However, the top quartile of managers in the Morningstar category modestly outperformed the index by 9 bps on an annualized basis.
During high yield market downturns, by contrast, actively managed funds have historically beaten the high yield index 78% of the time, based on market data from the past 12 years (see Figure 2). Over the same time frame, passively managed funds surpassed the index 50% of the time, in line with expectations for an index-tracking strategy.
Active management allows investment managers to be underweight sectors where they believe the outlook is less certain, often due to secular challenges (e.g., automotive, retail, wireline telecom). At the same time, active managers can overweight companies in generally more stable, defensive sectors such as medical products, consumer products, and packaging, while limiting exposure to more cyclical or commodity-oriented sectors in the face of economic uncertainty.
Drivers of active performance relative to passive
Structural factors within high yield markets help explain why actively managed strategies have historically outperformed passive during weak markets.
First, passive managers, in an effort to replicate the benchmark, often pay higher transaction fees. Those transaction fees tend to be exacerbated during weaker periods. That is, when the market is challenging and there are fewer buyers, passive managers may be forced sellers of specific bonds to maintain benchmark-like exposure, thus accepting a lower price than they would in a more buoyant market. In contrast, active managers can limit turnover, thus potentially reducing transaction costs.
The second reason for active outperformance during strenuous markets is that active managers have the option of being underweight bonds that they deem to have tangible impairment risk. Passive managers are not always able to avoid names that are part of their benchmark, meaning that they may be required to participate in bonds with a high probability of default. And with a historical default rate of 3.4% in high yield (according to Moody’s since 1996), portfolio composition plays an important role in limiting principal losses during a default cycle.
Market outlook and key takeaways
A credit market downturn is a risk investors should monitor and manage. PIMCO’s recent Secular Outlook highlights longer-term concerns about global credit markets – including the potential for market excess, dislocation, or correction – amid increasing corporate issuance and investor allocation to credit, in contrast to the decline in market liquidity for corporate bonds. Even if more stable conditions continue, there is the potential for a shift in the default cycle, perhaps during a period of prolonged below-trend growth.
We think this environment warrants caution on generic credit beta. This doesn’t mean there isn’t a role for high yield in an investment portfolio, however. High yield bonds may offer an attractive return profile, but active management is crucial. A focus on robust fundamental credit research, use of innovative analytical tools, and rigorous risk management are all important elements of a disciplined approach to portfolio management. The average historical high yield loss rate (i.e., losses due to default that are not subsequently recovered) is 2% since 1996, according to Moody’s. Prudent management of a high yield portfolio would seek to avoid the same loss experience as the market, but passive strategies face inherent challenges in doing so, and their lower fees may be scant compensation for the higher risks and more constrained return potential relative to active strategies.
Our analysis finds that data over the past decade support an active approach to high yield – an approach that invests with foresight and conviction, complementing rigorous credit research and risk management with thoughtful top-down views.
Learn more about why, in the active versus passive debate, we believe bonds are different.