To the surprise of many, interest rates—already low for most of the decade—have continued their slide across 2019. Due in no small part to current events like a potential economic recession and a trade war with China, rates on safe-money, 10-year U.S. Treasuries have dropped from 3.24% in November 2018 to as low as 1.45% this September.

These falling rates have been good for passive bond strategies. From here, however, it is reasonable to expect the fixed income market to be a bit more challenging. We believe portfolios will need an active component if they are to deliver satisfactory returns to their investors.

It’s Been Great To Be Passive

Everything can change in a matter of weeks. Owning the benchmark is usually fine in a rally, but what happens when things change? If rates do move higher, bond returns may move lower perhaps than they have in years.

The rally in rates has been stunning to watch. The Bloomberg Barclays U.S. Aggregate Bond Index is up 8.52% through September, while an index of U.S. corporate bonds is up over 13%.

While benchmark-driven bond funds have performed well, higher rates will by definition produce challenges for long-only, benchmark-driven bond portfolios. This will cause new money in long-only bond portfolios to lose money over the short to intermediate term as there is not enough yield in today’s market to make up for a meaningful price change.

What can bond investors do in such an environment? We suggest they look to investment strategies and portfolio managers that pursue pockets of potential alpha which passive strategies typically ignore. The differentiated return is called active share.

But It’s About Time To Get Active

Owning the benchmark might be fine, at least for a while. In fact, the markets may rally even further from here. But when a risk/reward trade-off becomes skewed against a long-only, buy-and-hold bond strategy, investors may seek out non-benchmark-like sources of return to bolster returns in their fixed income portfolios. The good news is that there are plenty of ways to add differentiated returns in today’s market.

Unlike benchmark-driven approaches, Shelton Capital Management believes an active strategy provides an opportunity to “lean in” to change. Nothing creates change like the volatility that comes with major market moves such as rising rates. In that environment, there will almost certainly be changes in absolute and relative pricing of at-risk assets along with variations in value between different sectors of the credit market, and swings in the yield curve. And there can always be changes, both good and bad, in the industries that make up the corporate space.

Our team at Shelton Capital Management looks at each fixed income security with a multi-dimensional view. Is it a good credit or a bad credit? Is it improving or deteriorating? And is it expensive or cheap? If an issue looks undervalued and improving in quality, we’ll probably want to own it. Beyond the long position, as an active manager, we also put all this good analysis to work on the short side. We think the ability to short situations we believe are headed in the opposite direction, overvalued and deteriorating, is critical for a bond strategy to outperform over the long term.

Distinguishing whether a manager is active or passive is based on how much of their portfolio is in an active share that’s different from the benchmark. To really add diversification to a portfolio, we believe the investment strategy should have at least 50% allocation to sources other than the benchmark. If a manager claims to be active, but 85% of the portfolio replicates the benchmark, the portfolio is nearly just a closet index.

Nobody Said It Was Easy

Bond managers need tools to accurately measure the risk and return metrics of their combined portfolio positions; when those measures change, managers need to be able to change with them. It takes work, but for managers willing to roll up their sleeves and do the analysis, we believe there exists ample opportunity to increase the active share of any portfolio.

An active management approach allows a manager who’s able to grasp the interaction between interest-rate and credit cycles to make better decisions about which way to lean as an active decision. It’s the best way we know to outperform in the fixed-income space over time.

Guy Benstead is a portfolio manager for the Shelton Tactical Credit Fund.