This increasing credit risk reduces the overall credit quality of most passive funds and many active funds that track to the BarCap Aggregate. Why? Because their mandates often restrict deviations from the index. This means they must take on the added debt of constituent companies, even if their underlying fundamentals are weakening.
Investors in these funds may not be aware that as their exposure to lower-rated debt increases, the overall credit quality of the funds is declining. When a recession occurs, these funds and their investors will take the biggest hit. As the default risk of these lower-rated issues skyrockets, prices will plummet, likely triggering a flood of outflows that will result in huge losses for these funds, since index restraints will limit their ability to selectively jettison their most damaging bond holdings.
Looking For Yield Premiums
An uncertain fixed income market favors managers who can be nimble and selective and focus on finding yield premiums and higher credit quality outside the larger issuer universe. For example, right now, bonds from highly rated (A to A-) smaller issuers offer a yield premium ranging from nine to 41 basis points higher than their larger counterparts, as shown in the chart below.
Some of this yield premium reflects the overall lack of market efficiency in the small end of the market. With mainstream investors favoring larger issuers, bonds from smaller companies are often undervalued, providing open-minded fixed income investors with opportunities to selectively exploit these opportunities.
Other yield premiums may be found among private placements. These fixed income issues, authorized by SEC Rule 144a, are generally only traded by qualified institutional investors and offer the benefit of shorter holding periods that range from six months to a year, compared to two years for other kinds of private placements. Over the past decade, these “144a securities” have offered attractive premiums relative to the BarCap Aggregate, as show in the chart below.
Why Smaller And Nimbler Is Better
With the BarCap Aggregate lumbering toward an inflection point, taking passive and larger active fund managers along with it, smart investors are seeking better risk-adjusted returns with more nimble managers and funds that focus on the smaller end of the fixed income universe. Because they’re not bound by broad index constraints, so-called smaller managers can rely on their own proprietary research tools to manage credit risk and identify yield opportunities.
Among active fixed income managers, those who funds have relatively low level of assets relative to funds with higher assets under management have certain advantages. They’re not pressured to hold hundreds or thousands of positions to keep the portfolio fully invested. They can identify yield premiums by using technical analysis to identify dislocation and mispricing opportunities within sectors or among individual securities. Their mandates often allow them to take advantage of yield premiums offered by private placements and other alternative investments. And when recessions occur, their smaller portfolios enable them to exit positions more efficiently and thoughtfully than larger firms that must quickly make hundreds of trading decisions to generate liquidity to accommodate outflows.
When the economy is on a roll, and markets are rising, investing in passive funds and active index-huggers often seems like a no-brainer. But when warning signs like weakening fundamentals and declining credit quality rear their ugly heads, prudent fixed income investors may be better off shifting some of their assets to smaller asset managers who may be better prepared to weather the approaching storm.
Dan Henken, CFA, is vice president of Securian Asset Management.
