The growth of passive investing is widely discussed by equity market investors, but less so in fixed income. This is because there are a number of differences between equity and bond indices that need to be taken into consideration when analysing the active versus passive debate, which we believe supports the case for active management. 
Index construction
First and foremost, equity market indices are dominated by the ‘most successful’ companies – those that continue to grow their business tend to increase in market capitalisation and become the biggest index constituents over time.
However, this is not the case in fixed income. The largest constituents of a fixed income index are those companies that have issued the most bonds. As a passive investor in a fixed income index, you are therefore exposing a large portion of your investment to the most indebted companies.
For example, one of the biggest companies in the UK equity market, GlaxoSmithKline, has a debt/EBITDA ratio of 1.73. In contrast, Electricité de France – which is one of the biggest constituents of a sterling corporate bond tracker – has a debt/EBITDA ratio of 9.28. This ratio highlights that the level of indebtedness is considerably higher at Electricité de France.
In this example, an index tracking fund will continue to purchase Electricité de France bonds in their relative proportion to the index as the company carries on borrowing, but most active managers, particularly those who do their own credit research, may question the wisdom of continuing to add to a company where the credit fundamentals are deteriorating i.e. ratings are declining and leverage is rising.
New issues and bonds not in indices
There is also the issue of turnover in fixed income indices, which are far more dynamic than equity markets. This is because old bonds are constantly maturing and being replaced by new bonds joining the index, but why is this negative for passive investors?
The fact that newly issued bonds do not become part of the index until month end rebalancing means that passive investors are missing out on opportunities to generate alpha by participating in new issues.
For active investors with their own credit research function, new companies coming to the bond market represent an opportunity. Such issues will often (not always, but often) be priced attractively, after all the company needs to encourage investors to sell out of other bonds and buy theirs.
It often happens that most of the alpha is generated in the first few days or weeks of trading as the credit spread on the new bond tightens in from where it was issued and this all happens before it enters the index. Even for established issuers it is often the case that new issues come with some discount to existing bonds that active managers can take advantage of.
Another source of alpha open to active investors lies in bonds that for some reason do not form part of an index. One example may be a bond without any ratings from the credit rating agencies. Just because a bond is not rated does not necessarily make it more risky, some very good credits and surprisingly well known companies can be unrated, for example John Lewis has had sterling corporate bonds for many years yet does not have a rating.
Again, investors with their own credit research teams are able to do their own assessment – and would not normally rely on agency ratings in any case – so these opportunities remain open to them but would not be for a passive investor.
Avoiding defaults
It is often said that while equity investors are glass-half-full people, hunting for the next company to double or treble in value, bond investors are glass-half-empty people in that they are trying to avoid the companies that get into difficulty and either restructure debt or default.
While defaults or restructurings are rare, if you passively own a little bit of everything then you will be hit by one sooner or later. In contrast, active investors look to avoid the potential problem credits. This has never been more important than in the current environment where yields are so low. A problem even in a small part of your portfolio can wipe out most of the income.
Adapting to the economic cycle
At present we are at a point in the economic cycle where we see growth as reasonably robust and interest rates likely to rise. This could well result in bond prices falling as they adjust to higher yields.
One way we try to help the LF Canlife Corporate Bond and LF Canlife Short Duration Corporate Bond funds withstand this potential negative impact, is to shorten duration and also invest in sectors with higher credit spreads, as that extra annual income over and above the underlying gilt or cash yield helps you withstand interest rate rises and still generate positive returns.
You can see below how the average spread on the LF Short Duration Corporate Bond fund is higher than its benchmark index, whilst the duration position, at approximately one year lower than the index, combine to make the fund better positioned for a rising interest rate scenario than a passive fund would be.
Source: Canada Life Investments & Markit, as at 30 Jun 2018
Mike Count is senior fund manager at Canada Life Investments. The views expressed above are his own and should not be used as investment advice.