The Power of Active Investing in Fixed Income

George Bory: My name is George Bory, chief investment strategist for the fixed income group at Allspring Global Investments. Today, we are discussing the power of active investing in fixed income. Active investing provides three specific benefits to investors. One, active investing puts investors first by helping to level the playing field between lenders and borrowers when an entity borrows money and really puts the needs of the lender ahead of the borrower. Two, active investing is also low cost. What I mean by this is that the true cost of investing combines management fees with opportunity costs. And since passive investing only accounts for the fee without an opportunity to earn it back and more, you're virtually assured underperformance. And over time, that opportunity cost can grow and weigh on portfolios. Active investing strives to generate returns in excess of management fees and have historically been able to do so. As a result, active investing may be a lower cost alternative to passive investing when adjusted for total costs. And then, three, active investing exploits structural inefficiencies inherent in bond markets. A bond is simple, but the bond market is complex. It consists of about 55,000 different issuing entities and more than 1 million different securities. This stands in sharp contrast to the equity market with only about 3,500 different issuers around the world, each issuing just one security. It's this complexity that results in sharp market segmentation, as different bond investors try to control for different types of risk, and they value securities differently when they look through different lenses. This complexity is further compounded by the creation of a wide range of benchmarks, which results in rigid rules for inclusion, deep demarcations across markets, and persistent pricing discrepancies, all of which can be exploited by the active manager. Now, imagine you've just left your school reunion and one of your classmates offered you the opportunity to invest in your class by lending the class money. You can either lend them all money with the most indebted classmates getting the most amount of money or you can spend some time selecting amongst your classmates who you want to lend money 92% and who you don't want to lend money to. So, which would you choose? A good active manager has a playbook to choose the latter, to help navigate the pitfalls of investing in bonds, and to generate additional returns to offset those costs of active management. Now, our classmates want the lowest possible interest rate with the fewest restrictions over the longest period of time, whereas you, the lender, want to earn the highest interest rate possible. You want a tightly written contract and you want to receive your payments on time. Now, this creates an inherent imbalance between your needs and the objectives of your classmates. A passive investor casts a blind eye to these imbalances and simply lends money to everyone with the classmates with the most amount of debt getting the most amount of money. Furthermore, you participate in a broad range of debt securities that each borrower has already issued. In today's bond market, one of the largest borrowers, a U.S. bank, has over 1600 different bonds with different maturities, coupons, and levels of subordination and options. This stands in sharp contrast to the equity investor who only gets to choose one security for each issuer. Active investing in fixed income helps solve for these imbalances and shifts the balance in favor of the investor and away from the borrower by focusing on a discrete number of issuers and issues that matches the investor's preference. Unfortunately, not all of our classmates were successful. Some were wildly successful in life, while others weren't. Some borrowed huge sums of money, while others were incredibly tight fisted and frugal. Now, a passive investor simply captures the whole lot and indiscriminately lends to everyone. Active investing attempts to identify those borrowers with the highest probability of meeting the terms of their debt contract, while avoiding those who may not. Now, since a bond pays off at par and not a cent more, avoiding the downside is just as and, in some cases, more important than picking the best borrower. Active investing attempts to avoid borrowers that may have difficulty paying back their debt, and in doing so, helps preserve an investor's income and the returns in their portfolio. Each classmate is also different. Some work in advertising, some in manufacturing or technology, others in finance, some may not work at all. Some may live in the U.S., others may live in other countries. Some may have lots of existing debt, others none. But lenders are also different. Some may need their money back tomorrow, others not for 30 years, others on a very specific date. Some may pay high taxes, others pay no taxes at all. Some may require high regular payments over time, while others may want their money back at the end of the contract. It's these differences that create deep segmentation across the bond market, as what's valuable to one borrower or lender may not be valuable to another. These rigidities result in persistent inefficiencies and price inconsistencies across the market. The spread between the worst performing sectors of the bond market can potentially be as tight as 5% or less, or upwards of 30% or more in a given year. One of the biggest and most arbitrary divides in the market is between investment grade and high yield issuers. The rating agencies tell us a high yield credit is approximately five times more likely to default than an investment grade issuer over roughly a 5-year period. Therefore, many investors paint a bright line between the two sectors, which forces a passive investor to buy or sell when a borrower changes category regardless of price. This creates meaningful pricing discrepancies amongst issuers in this crossover universe. For example, the yield difference between BBB and BB borrowers typically averages about 1.5% but has been known to get as wide as 5% and as tight as one half of 1%. Active investing attempts to capture this discrepancy, to generate additional returns in the portfolio, and help performance over time. Active investing in fixed income can be a powerful tool to help generate additional returns in portfolios. It can cover the cost of management fees and boost the spending power of a portfolio over time. Allspring manages about $460 billion of assets under advisement in fixed income and our track record is evidence of the power of active investing. By putting our clients first, keeping costs low, and exploiting the structural inefficiencies across the market, 92% of our fixed income composite assets outperformed their corresponding benchmark for the 5-year period after fees. This underscores our mission to elevate investing to be worth more.