Bond funds have delivered positive returns for decades. But investors can thank secular disinflation and falling interest rates, not their own decisions on where to place their bets or the moves of active managers. Investors, asset managers, advisors and consultants are now debating new models of bond investing as the tailwinds start to die down and losses pile up.
Richard Bernstein, a former Hall-of-Famer on Institutional Investor’s All-America Research Team, argues that the traditional buy-and-hold strategy is unlikely to perform well in an environment of rate hikes and persistent inflation. According to the latest report from his advisory firm, Richard Bernstein Advisors, fixed income investors have historically tended to buy and hold bonds and fixed income assets, in part because of the difficulty in determining the correct allocation decisions. But buying and holding may not work in a changing economic landscape, even if it hasn’t gotten any easier to forecast macro moves.
Bernstein told Institutional Investor, “During the bond bull market, one really didn’t have to manage duration or credit effectively because the bull market hid mistakes. In a bear market, there is nothing to cover mistakes so bond investors will have to be “true” — and successful — active managers.”
There’s long been a debate, well before the current meltdown, about whether active managers of bonds can deliver returns above a passive fund. Bill Gross, who ran Pimco’s total return fund and arguably invented active bond management, doubted whether he really generated alpha, given the tailwind of declining interest rates he enjoyed for decades. In a 2019 study AQR found that instead of delivering “true alpha,” active fixed income managers had been mostly “repackaging” traditional risk factors such as duration, corporate credit, emerging markets, and volatility risks.
Bernstein analyzed data from Dalbar’s 2021 results on the performance of the average bond investor, which found overall that while buying and holding fixed income has helped generate positive returns in the bull market, it did not help them outperform benchmarks and index funds. The most recent 20-year annualized return of an average investor in fixed income funds didn’t even outrun that of treasuries and other bond benchmarks. “Their timing decisions were so poor that they underperformed any buy-and-hold strategy in any fixed-income classification,” the report said.
“We believe we are at the start of a pro-inflation paradigm shift, which will challenge traditional buy-and-hold fixed-income investing,” according to the report. “If active individual fixed-income investors performed so terribly during a secular bull market, it seems quite a challenge to expect them to perform well during a less advantageous secular period.”
The solution, according to RBA, is to be more creative, more tactical, and more active. Investors should look for unique asset classes and hedging strategies. For example, floating-rate bonds have proved to be a great hedge against rising interest rates.
“I think it is a combination of looking for different sub-asset classes within fixed-income and decidedly changing those positions as the economic cycle changes,” Bernstein said. Investors will need to move from long to short duration and along the credit spectrum. “Institutions have focused on the newest ‘sexiest’ fixed-income asset class as opposed to shifting among them,” he added.
It was only natural for investors to be less active about their bond allocations when the market was on an upward trend. An active fixed income investor “would have had to make roughly 16 important allocation decisions in the last 10 years,” according to the report.