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Beware of Passive Indexing in Fixed Income

Ken Taubes
calender-icon Posted on August 31, 2012


It’s long been a concern of mine that many fixed income investors turn to indexed or index-like portfolios without knowing a principal risk: their exposure to government bonds at a time when debt levels are increasing and interest rates are at 60-year lows comes at the expense of owning other types of corporate bonds that might better serve their investment needs.

Often a core fixed income investment takes the form of an indexed or index-like portfolio based on the Barclays Capital U.S. Aggregate Index, one of the most widely used measures of the “broad” U.S. investment grade bond market. Over time, however, as government borrowing increases, the index’s proportion of government holdings increases in order to reflect the investable universe. We view this as a risk and one more reason why an active, value-based multi-sector approach may be a better way to invest.

We believe that fixed income indices may be appropriate as benchmarks, but not as investment strategies. Even broad market indices like the Barclays Capital U.S. Aggregate Index close off a large part of the opportunity set within the fixed income universe, including floating rate sectors, Treasury Inflation Protected Securities (TIPS), convertible bonds, municipals, non-U.S. dollar bonds and non-investment grade issues that can play a key role in adding return and diversifying risk within a fixed income portfolio.

Particularly at this time, with over 70% of Index exposure to U.S. government-related issues (see chart), increasing U.S. debt levels and a 60-year low in interest rates, this widely recognized investment grade index exposes investors to greater potential downside interest-rate risk than ever before in its thirty year history.

In most investors’ minds, fixed income typically doesn’t offer significant capital appreciation—that’s the role for equities—but at least it seeks to protect principal as well as provide a modest income stream. For all of the reasons above, however, active rather than passive management may be a better way for fixed-income investors to achieve their long-term goals.

 

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