Everything that’s wrong with passive bond funds

Interest rates are on the way down in the UK. That is traditionally good news for bond funds. But for passive corporate bond funds it could be a different story. I am bound to argue that trackers are crackers when it comes to bonds but hear me out and I hope you’ll agree.

First, a bit of market context. Donald Trump appears to be back-pedalling on tariffs, but the repercussions continue. Growth, globally, will suffer. That said, we are starting from a place where unemployment is very low, wage growth is healthy and corporate leverage is low. We also know that slower growth will bring rate cuts which will be supportive of markets.

The markets already know weak economic data will start to appear at the end of May and into June – a ‘known known’ – but the extent of the economic damage remains a ‘known unknown’. In boxing they say it’s the punch you don’t see coming that knocks you out. But we think the worst of the damage has been done already. There will be volatility as we lurch from economic headline to economic headline. But we know these punches are coming and we are not expecting the market to fall over.

There will be volatility as we lurch from economic headline to economic headline. But we know these punches are coming and we are not expecting the market to fall over.

When things are so uncertain – and interest rates appear to be heading down – you usually want to have plenty of interest rate risk (‘long duration’ in bond market parlance). However, in the Artemis Corporate Bond Fund, we are meaningfully underweight long-dated bonds. The fund’s weighting to bonds with more than 15 years until maturity is 14.4%, compared with 16.7% in the index¹.

Importantly, even that exposure is concentrated around the 15-to-20-year zone, with nothing beyond 30 years to maturity. The combination adds up to a meaningful underweight to long-dated bonds. This leaves the fund with a modified duration of approximately 5.5 years compared with approximately 5.75 years from the index². This is not what the textbooks tell us to do when interest rates have fallen (and the Bank of England base rate is predicted to fall from 4.25% today to approximately 3.5% by year end³).

So why go short? Yes, the weakness in economic data that will come through will meaningfully increase the pressure for central banks to cut base rates. But lower economic growth will require higher borrowing levels, pressuring longer-dated bonds with increased supply and occasional concerns about debt sustainability.

While we expect the bond markets to be largely rangebound for the rest of the year, the pressure on steeper yield curves remains. This means that as the Bank of England base rate falls, shorter dated bonds will benefit, while the impact on longer-dated ones will be limited.

Investors in gilts shouldn’t panic

But before we get too panicked about government bonds and gilts in particular, there are things that can be done.

The UK has the luxury of having issued vast amounts of very long-dated government bonds and has locked in very low coupons for a very long time. It has a much longer average maturity of its debt than all other countries, almost twice as long as most other developed nations⁴. It can very easily tilt issuance to shorter maturities without running into liquidity problems, which it has been doing.

While we expect curves to steepen, we are not expecting things to get out of control. The market will benefit from rate cuts, but that favours shorter maturities more than longer maturities and hence we will retain our curve-steepening position for the foreseeable future.

Time to move on from bond trackers

If our view on markets is right, index-tracking corporate bond funds face a challenge. They obviously can’t pivot their positioning. They are locked in to a full weighting of long-dated bonds, whether that’s a good idea or not. They can’t put on the curve steepener.

There are a few other things they cannot do either. Most investment-grade companies issue a variety of bonds, often in sterling, dollars and euros, some shorter dated and some longer dated. Active funds can cherry-pick the bonds that have the most value and ignore the expensive ones, something passives obviously can’t do.

Active funds can cherry-pick the bonds that have the most value and ignore the expensive ones, something passives obviously can’t do.

They focus on the largest bonds in the market. It means that when there’s anxiety and people want their money back, all these passive funds are selling the same bonds at the same time. This creates interesting opportunities for the nimble to pick up oversold bonds cheaply.

Further down the credit spectrum the mispricing opportunities created by passive trading become even greater. In the high-yield market the index is more heavily weighted towards the companies with the most debt in issuance. It’s the equivalent of equity indices having the greatest exposure to the companies with the biggest market cap. The difference, though, is that companies that borrow a lot are not necessarily the ones you want to have exposure to.

I could go on. But how does this pan out in the numbers? Over the past five years, trackers rallied less in up markets and fell more in down ones relative to their actively managed brethren – the difference in returns in the investment grade arena is 5.5% – and that’s mapping trackers against only average bond funds⁵. Against a good actively managed corporate bond fund the difference can be significantly greater.

If investors are concerned about government bond curves steepening, I would argue that selling down your index trackers may be a good place to start.