The decade-long bull market has made a strong case for passive investing in equities, and some of this sentiment has convinced many fixed income investors to do the same. But the arguments for passive equity investing don’t fly for passive fixed income investing. As economic growth slows in the U.S. and around the world, it may be signaling the end of the current credit cycle, which may increase risk for passive fixed income investors or those who invest in actively managed fixed income funds that use the Bloomberg Barclays U.S. Aggregate Bond Index (the BarCap Aggregate) as a bogey. A better choice may be to consider nimble and flexible active managers who offer a more selective approach offering greater defense against economic recession.

The End Of Credit Cycle May Be Approaching

Ten years of economic growth and mostly positive market returns has created a false sense of security that the good times will last forever. But a recession is inevitable. The only questions are when and how bad.

There are already signs that a downturn may be on the way. The Federal Reserve’s recent cut in interest rates was a reaction to slowing economic growth both in the U.S. and China, reduced business spending, plateauing corporate earnings growth and anticipation of trade-war driven instability. A historically low unemployment rate is making in next to impossible for many companies to add the workers they need to scale up production.

Fixed income investors, who often have an uncanny ability to sniff out recessions before everyone else, have on several occasions this year inverted the yield curve, locking in lower yields on long-term Treasury notes while demanding higher yields from short-term Treasury bills. Historically, inverted yield curves have predated recessions.

In such an environment, the one size fits all attraction of passive and active fixed income funds that track to the Barclays Capital US Aggregate Bond Index (BarCap Aggregate) can actually expose investors to a greater variety of risks than those associated with equity index funds. Here’s why.

Diminishing Credit Quality 

Many investors consider the BarCap Aggregate to be the bond world’s analogue to the S&P 500. But this is a foolish assumption. The only thing they have in common is that they’re comprised of securities issued by larger companies. Their risk characteristics are quite different.

Weightings in the S&P 500 rise and fall with the market capitalization of the companies that comprise the index. Conversely, weightings in the BarCap Aggregate reflect the number of bonds each company issues, subject to the index’s credit quality standards.

Here’s the problem. In recent years, many lower-rated companies in the index have taken on more debt, which is giving these companies higher weightings in the index.

The chart above shows that a hypothetical buyer of the index would historically have received less compensation for holding riskier credits.

Currently, option-adjusted spreads for the BarCap Aggregate are hovering around 75% of its 10-year average. During this time, the weightings of BBB-rated issues have risen by almost 20% and now constitute more than 50% of the index’s investment-grade debt.

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