Active bond managers are licking their wounds amid this year’s historic fixed-income rout and are banking on a big rebound in 2023 to show their worth.
Roughly 60% of the funds pegged to Bloomberg’s flagship bond-market index have trailed the benchmark this year, the worst showing since 2018. That means most investors turning to bonds for a semblance of shelter from this year’s carnage in markets would have been better off in cheaper, passively managed index funds.
It’s a humbling display for active managers, who typically beat their benchmark by nimbly shifting between Treasuries, corporate debt, mortgages and asset-backed securities to tap the best opportunities. But 2022 has obliterated almost every corner of fixed income, with a punishing selloff fueled by aggressive Federal Reserve interest-rate hikes to tame stubbornly high inflation.
“There’s been nowhere to hide in 2022 and cash was king,” said Jack McIntyre, a portfolio manager at Brandywine Global Investment Management. “Clients don’t pay you to stay in cash for a long time.”
Active managers still dominate the US bond market, with assets totaling $3.6 trillion, up from $2.4 trillion in 2012, according to Morningstar Direct data. But index funds are growing rapidly: Their assets have surged more than 400% in that period to $1.9 trillion.
Inflection Point
The active crowd has reason to take heart as the market may finally be approaching an inflection point. Treasuries are coming off their first weekly gain since July, and softening growth is setting up a possible pivot in Fed policy that could give portfolio managers a chance to outshine their peers with sector calls and bond-picking skills. While officials are expected to deliver a fourth consecutive rate increase of 75 basis points on Wednesday, bets are mounting on a smaller boost at the central bank’s next meeting in December.
History is on the side of active managers. In the past decade, there have only been three other times when the median trailed the benchmark. In the two most recent instances, the next year brought redemption, with 70% or more outperforming the benchmark as the bond market snapped back with a stronger performance.
It would be hard to imagine a tougher environment than 2022. The 10-year yield peaked at 4.34% in October, the highest since 2007, from 1.5% at the start of the year, and the main Treasury index has tumbled 14%, dwarfing all prior annual declines.
“In the last 20 years, it’s been almost risk-free for bond fund investors,” said Russel Kinnel, director of manager research at Morningstar Research Services LLC. This year has been “a sobering reminder that bond funds of all stripes have risks.”
The preference of late is to allocate money to longer-dated bonds as the Fed’s inflation-fighting campaign increases the prospect of rate cuts starting next year. It’s an outlook that should generate price appreciation, reigniting the twin engines of fixed-income total returns. Bonds provide a regular income stream, while falling rates would drive price increases. This year, an income gain of roughly 1.3% in the main Treasury index has hardly offset a price decline of about 15%.