Active versus Passive Fixed Interest Management:
Opportunities for Adding Value

There are several options investors have for adding bonds to their portfolio. One is to invest with an “active” fixed interest manager that employs various strategies to maximise the return on a portfolio in a bid to outperform the market's return, measured by a selected benchmark. A second option is to invest with a “passive” fixed interest manager whose goal is to replicate the returns of the bond market or a specific sector of the bond market.

The merits of active versus passive management strategies have been a source of long debate. The key contention is whether the bond market is too efficient to allow active managers to consistently outperform the market itself. The active bond manager argues that both size and flexibility enable active managers to optimise short and long-term trends in order to outperform the market.

There are two major sources of inefficiency or opportunity that exist in the bond market that can be actively exploited. First, in the fixed income market there are a large number of risk characteristics including interest rate risk, sector risk, option risk, yield curve exposure, reinvestment risk, credit risk and liquidity risk. The measurement of many of these risks has become increasingly complex as fixed income securities themselves have become more complicated. One way of actively managing a bond portfolio is to identify mispricing of risk or undervaluation within the market.

The second area of opportunity for active bond managers arises from superior macroeconomic forecasting. Fixed interest managers can add value by setting overall risk characteristics such as duration, convexity, sector exposure, and yield curve exposure, differently from the market or benchmark against which they are evaluated.

Active bond managers commonly adjust a bond portfolio's duration (the weighted average duration of all the bonds in the portfolio) based on an economic forecast. For example, in anticipation of declining interest rates an active manager may lengthen a portfolio's duration because the longer the duration, the more price appreciation the portfolio will experience if rates decline. On the other hand, a bond manager expecting interest rates to rise would normally shorten the bond portfolio's duration by buying shorter-term bonds and selling longer-term bonds. In the event of rising interest rates, the price of a shorter-duration portfolio should fall less than that of a longer-duration portfolio.

Another active bond investment strategy is to adjust the credit quality of the portfolio. For example, when economic growth is accelerating, an active manager might add bonds with lower credit quality in the hope the bond issuers will experience credit improvement with the positive change in the economy, and the bond prices will rise. Active managers also take advantage of strong credit analysis capabilities to identify sectors of the market that seem likely to improve, and potentially increase a portfolio's return.

A third active bond strategy is to adjust the maturity structure of the portfolio based on expected changes in the relationship between bonds with different maturities, a relationship illustrated by the ‘yield curve'. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment.

When the market turns, as it did in the latter half of 2007 as a result of the US sub-prime crisis and the resulting credit and liquidity crunch, a good active manager should be in a position to cushion their client's portfolios from the downward market trend.