Jack Bogle, the legendary founder of Vanguard and a longtime champion of index fund investing, was on financial television recently making the case that
the arguments for index investing hold just as much for bonds as stocks. The academic literature is replete with studies making the case against active
management. At the core of the argument is some basic math: In sum, the performance of all investors aggregates to the performance of the markets. For
every winner, there must be some loser who is subsidizing the winner’s gains. Throw in fees, and the average net return above the market for active
investors is negative.
The logic is fairly compelling, and at first blush, it would seem natural to assume it also fits the fixed income world. However, there are a number of
reasons why investors should question extending the common wisdom to fixed income. Here are five important ones.
1. A significant fraction of investors in fixed income markets have primary objectives that differ from maximizing mark-to-market total returns.
Central banks buy and sell foreign bonds to stabilize exchange rates and trade domestic-currency sovereign bonds to manage the money supply. Commercial
banks and insurance companies often make investment decisions based on returns on risk capital, agency credit ratings and accounting measures. For them,
book yield may dominate total return, as evidenced by the general tendency for larger holdings to be classified as “available for sale” rather than in the
“trading account.” They prize predictable, steady income – mainly from coupon payments – and generally shun capital gains and losses, which are seen as
lower-quality earnings by equity analysts. The majority of these investors also treat the investment grade threshold (triple-B-minus/double-B-plus) as a
perilous cliff to be avoided.
Figure 1 summarizes the fixed income balances held by these investor types. Note that of the approximately $101 trillion in global fixed income assets, as
reported by the Bank for International Settlements, approximately 50%–55% are held by non-mark-to-market investors.
To the extent these objectives differ from those of pure mark-to-market investors or these constraints bind with some embedded cost, some value must be
transferred to those who are not similarly constrained.
2. Unlike equity indexes, where the market determines the weights, in bond indexes issuers principally determine the weights.
With the exception of the Dow Jones Industrial Average, most commonly referenced equity benchmarks are market-weighted, with weights determined solely by
the market capitalization of the companies. Most companies have a single publicly traded share class, or at most two.
Bond indexes are different. They are driven largely by how much debt a company or government chooses to issue and the size of an individual security
issued. If a company issues more debt, it is not fundamentally affecting the aggregate value of the company – cash coming in is an asset, debt added is a
liability: Cash – debt = 0. However, when a company issues more debt, it is adding to its weight in a bond index. Should a company’s capital structure
decision be sufficient to drive an investor’s decision to hold the issuance? Does it make sense to increase holdings in a company’s liabilities because a
company increases financial leverage?
Typical bond indexes also have thresholds for inclusion given the complexities of monitoring the indexes and the sheer number of outstanding issues. For
Barclays indexes, that threshold is $250 million. Imagine triple-B-rated Acme Enterprises decides to issue $1 billion to fund a new factory for roadrunner
traps. Given its cash flow forecasts and advice from its bankers, the company decides to spread out maturities and issue $500 million in five-year, $300
million in 10-year and $200 million in 30-year bonds. Barclays Credit and Aggregate indexes will increase Acme’s representation by $800 million – not $1
billion. There will be pricing impact on the 30-year bonds as index buyers will not hold them.
Across the corporate universe, there are companies with a single equity share class that is included in one or more equity indexes and with dozens, if not
hundreds, of individual debt issues, but the fraction of their debt included in indexes may vary widely.
3. The new issuance market is much more important for bonds than equities.
In 2013, total U.S. corporate bond issuance was approximately $1.4 trillion against an outstanding balance of $7.4 trillion, according to the Securities
Industry and Financial Markets Association (SIFMA), while U.S. equity issuance was $255 billion against a total market value of over $22 trillion (much
less if secondary equity offerings are excluded). Thus, the annual turnover in the corporate bond market is 20% versus a little over 1% for the equity
market. This would stand to reason as common equity is generally a perpetually lived security whereas bonds have finite maturities. Given these figures, an
active presence in the issuance market can materially impact performance for fixed income investors, whereas its contribution to equity performance is
rarely more than a rounding error.
As new bonds typically come to market at a slight discount to outstanding issues to entice investors, a strong presence in the new-issue market can add
incremental value for two reasons. First, investment banks do not treat all comers equally – allocations are not made pro-rata or based solely on an
investor’s size, although size matters. There are a host of other factors taken into account to ensure a successful syndication. Second, not all new issues
will tighten, or increase in price, equally after issuance. Strong credit analysis and understanding of trading technicals are essential to knowing when to
participate aggressively in a new issue or to pass.
4. Most bond trading is done via over-the-counter transactions and not on exchanges.
Exchanges work when the items listed on the exchange are of a manageable number and there is a high degree of standardization. There are approximately
5,200 listed equities in the U.S. spread across a few exchanges. PIMCO’s databases track nearly 220,000 U.S.-dollar-denominated fixed income securities,
and we are constantly adding new ones because of new issues or because we have not held a specific issue previously. Bonds from a single issuer may vary in
terms of covenants or indentures. Two 10-year bonds from a single issuer may not be perfect substitutes!
Because of this, the majority of bond purchases and sales are not simple orders, but are negotiations. The outcome of any negotiation is
determined not only by the object of interest, but also by factors affecting the two parties negotiating. Edwards et al. (2007) document a host of factors
affecting bid-ask spreads and ultimate execution using TRACE data from 2003−2005. The results are fascinating, and clearly suggest that size is a
significant advantage in execution.
5. Individual bond returns are highly skewed versus stock returns, which are more symmetric.
The percent return on any given stock conforms roughly to a random walk with a long-term upward trend. Consequently, when you aggregate individual holdings
in portfolios, the rate of convergence under the Law of Large Numbers (LLN) is fairly rapid. The return on a bond is quite different. Over the life of a
bond, the most a bond can return is principal and interest. This is the result for most bonds. But some bonds return far less due to default or other
reasons, such as (forced) premature sale by the investor due to a credit rating downgrade. Aggregating across holdings, convergence to the LLN can be slow.
The higher the quality of the index, the slower convergence will be.
In active management, meaningful alpha can be added to a fixed income portfolio by playing offense when the time and circumstances warrant, but a
significant amount of value, if not the majority share, is added by a strong defense.
There are a host of other ways active managers can add value – prudent use of derivatives as substitutes for cash bonds, understanding mis-valued imbedded
options and risk premia due to policy or regulatory factors, etc. – and these have been written about extensively over the years.
The key question for investors is, “Do I have strong reason to believe my active managers will add value in excess of their fees?” I would
not argue that all do or even that a majority do, but those managers who understand and exploit the five reasons I list, plus a host of others, stand a
very good chance.
Finally, should we just restrict our use of active managers to bonds given the evidence Bogle, Malkiel and many others present? Not so fast … In “Can
Mutual Fund ‘Stars’ Really Pick Stocks?” Kosowski et al. (2006) use modern high-powered econometric techniques to refute some of the common wisdom derived
from extensions of the LLN. To quote from their abstract:
Specifically, we find that a sizable minority of managers
pick stocks well enough to more than cover their costs;
moreover, the superior alphas of
these managers persist.
So much for the common wisdom.
Edwards, Amy, Lawrence Harris and Michael S. Piwowar, “Corporate Bond Market Transaction Costs and Transparency,” Journal of Finance, v 62 (3) June 2007,
Kosowski, Robert, Allan Timmermann, Russ Wermers, and Hal White, “Can Mutual Fund ‘Stars’ Really Pick Stocks? New Evidence from a Bootstrap Analysis,”
Journal of Finance, v 61 (6) December 2006, 2551-95.