Shrewd investors may have soured on high-yield bonds due to recession fears, but the sector continues to offer diversification benefits, not to mention record issuance and fairly robust corporate fundamentals. Wall Street jawboning may foretell a large spike in corporate defaults if the economy tanks, but the data tells a different story — at least for now.
Of course, high-yield bonds aren’t without risks. Bonds with credit ratings below BBB or Baa3 aren’t immune from volatility, economic stress, or other issues impacting issuers. Still, there’s an advantage in high yield, especially as part of an actively-managed portfolio.
A recent insights report from T. Rowe Price made a strong case for actively managing high-yield bonds. In the view of portfolio specialists Kevin Loome and Ashley Wiersma, active management offers several advantages over a passive strategy, including the ability to properly conduct fundamental analysis, avoid costly indexing strategies, and control the holding period of bonds.
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Active Management Enables Fundamental Analysis
A set-it-and-forget-it portfolio strategy may work for long-term investments, but it’s not ideal for modern high-yield portfolios, which require nimbleness and the ability to capitalize on emerging macro trends. Fundamental analysis, or in-depth research of an underlying security to determine its fair value, can help investors uncover new opportunities, such as credit rating upgrades or downgrades, changes in an issuer’s business strategy, or other factors that can determine whether the issuer is over- or undervalued by the market. The benefit of fundamental analysis becomes more apparent when we consider that an issuer’s credit rating is primarily an assessment of its ability to repay the bond. Active management enables us to evaluate the issuer’s financial health more closely.
High-Yield Indexes Are Difficult and Expensive to Replicate
The T. Rowe Price analysis is correct to highlight the pitfalls of passive investing in high-yield, given the underlying challenges and complexities of replicating high-yield indexes. Unlike stocks, the bond market is large and complex. Consider that the S&P 500 Index—the primary bellwether of the U.S. stock market—has 500 constituents compared to nearly 2,000 issues from roughly 925 issuers in the ICE Bank of America High Yield Constrained Index.
Managing a passive portfolio with hundreds of issues is further complicated by immense trading costs because high-yield fixed income is primarily traded over the counter rather than on an exchange. If you go the passive route, beware that bond benchmarks have a lot higher turnover than most stock indexes.
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Active Management Allows You to Control the Holding Period
One of the most significant benefits of active high-yield management is the ability to control the length of time a bond is held.
As the Corporate Finance Institute explains, passive funds usually hold a bond until it matures, reducing portfolio profitability. Selling bonds before maturity can be more advantageous, especially if they have a lower yield and shorter duration. In an environment of rising interest rates, selling shorter-duration bonds can increase the portfolio’s overall yield. The ability to control the holding period reflects what T. Rowe Price called “nimble positioning” in its report. Active managers can apply fundamental analysis and other investment techniques to position their portfolios to align with the broader market outlook based on economic trends, monetary policy, and other value assessments.
In the years following the 2008 financial crisis, investors have been told that passive strategies outperform active management over more extended periods. While there is certainly merit to this argument, the axiom broadly applies to stock markets, not bond markets. In today’s investing climate, active management has much to offer high-yield bonds.
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