By and large, fixed income investors tend to be a conservative lot. And under that guise, they don’t like surprises. They like to sit back, collect their coupons, and enjoy a steady return. So, when anything upsets the apple cart, they tend to go into a tizzy. The recent upsetting? The U.S. debt downgrade, which sent the broader bond market reeling.
However, it did not cause the entire bond market to fail. In fact, several pockets strengthened on the news.
The downgrade could serve as a strong underline that not looking like an index and going outside the norm can pay benefits. To that end, active ETFs and active management in the fixed income sector can save the day.
A Big Downgrade & Treasury Uncertainty
Expressing skepticism over current fiscal proposals and that these proposals are unlikely to materially reduce deficits, credit agency Moody’s downgraded the U.S. long-term issuer and senior unsecured ratings from Aaa to Aa1. Moody’s is now the third major credit rating agency to downgrade the U.S., following S&P Global and Fitch back in 2011 and 2023, respectively. Moody’s has had the United States as a pristine “Aaa” rating since 1919.
The market reaction was mixed.
The yield on the benchmark 10-year barely moved, while the S&P 500 index saw a slight increase of 0.09% on the day. Analysts chalked the mixed movement up to the fact investors telegraphed the news and had been expecting the downgrade for a while. But just because the market reaction was muted doesn’t mean all is well in bond land. Digging under the surface reveals something a bit more ominous.
Rising debt levels have continued to boost the yield on Treasury bonds and keep them higher. This is despite the Fed cutting rates. With tax proposals expected to increase the Federal deficit by about $7.8 trillion over the next decade, so-called bond vigilantes have stepped in and are now worried about federal fiscal health. As such, they’ve started to demand more from the Treasury to compensate for these growing risks. Bond yields have started to creep higher.
And with that, Treasuries aren’t acting like they normally would. This chart from T. Rowe Price shows just how Treasuries are behaving amid market uncertainty and the fiscal woes/bond vigilantes are influencing the change.
Source: T. Rowe. Price
The Case for Active Management
Clearly, today’s Treasury market is behaving weirdly and the debt downgrade adds new fuel to the fire. That strange behavior and investors wanting more yield to compensate underscores why being passive may not be the right answer.
The easy answer is to look at the major bond benchmark, the Bloomberg U.S. Aggregate Bond Index, or the Agg for short. At first glance, the Agg doesn’t appear to be a bad index. It offers plenty of diversification, with over 11,000 different holdings.
However, despite the sheer number of bonds in the index, the market-cap weighted nature of its construction causes flaws. Here, the Agg creates its weightings based on the amount of debt outstanding. That is, the firms with the most debt get a higher place in the index. Essentially, you’re rewarding the biggest debtors with more pull on the index. In the case of the Agg, that’s the U.S. government. Today, that number is close to 46% of the benchmark. What’s worse is that as U.S. debt grows—as it is expected to do—Treasuries will take hold of more of the index.
That’s a huge issue considering the volatility of Treasury prices and continued pull toward higher yields.
However, active management doesn’t have to look like the Agg.
Active managers have some flexibility and leeway when selecting securities, even those who focus on intermediate investment-grade such as what the Agg tracks. They are allowed to play with the index construction to build a portfolio outside of the Agg. So, if a manager feels corporate bonds offer a better deal than Treasuries, they can buy them. If they are worried about duration, they can go down the ladder as the Agg includes bonds with at least one year left until they mature. And depending on mandate, core-plus managers can even hold some exposure to non-investment-grade debt.
This active touch allows managers to take advantage of the entire bond spectrum without having to solely load up on Treasuries like the index. And that should help reduce risk, boost returns, and lower much of the volatility facing Treasury prices.
According to recent J.P. Morgan research, over the three-, five- and 10-year periods, active intermediate core and intermediate core-plus funds managed to provide excess annualized returns versus the parent Agg index. For example, intermediate core and intermediate core-plus provided 0.07% and 0.34% in extra return, while the Agg managed to provide a -0.29% return.
Making an Active Fixed Income Play
Given the Treasury market’s uncertainty and volatility, going active with your fixed income portfolio could be the best bet to save your portfolio from some hefty potential losses. Overall, there are plenty of opportunities outside the realm of the Agg that could be great in a portfolio.
Thanks to the active ETF boom, there are now numerous choices that operate within the core-plus and dynamic income segments of the bond market. By purchasing one or two of these, investors could insulate themselves from the issues facing the Agg index and treasury prices.
Core-Plus & Dynamic Income ETFs
These ETFs were selected based on their low-cost exposure to active bond management within the unconstrained, dynamic, and core-plus sectors. They are sorted by their YTD total return, which ranges from 1.5% to 2.5%. They have expenses between 0.18% and 0.71% and assets between $138M and $31B. They currently yield between 4.3% and 7.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| BOND | PIMCO Active Bond ETF | $5.5B | 2.5% | 5.3% | 0.71% | ETF | Yes |
| TOTL | SPDR DoubleLine Total Return Tactical ETF | $3.5B | 2.3% | 5.1% | 0.55% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $30.7B | 2.2% | 4.5% | 0.18% | ETF | Yes |
| FBND | Fidelity Total Bond ETF | $18.1B | 2.2% | 5% | 0.36% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $12.8B | 2.1% | 4.8% | 0.35% | ETF | Yes |
| BINC | BlackRock Flexible Income ETF | $8.14B | 2.1% | 5.5% | 0.52% | ETF | Yes |
| JCPB | JPMorgan Core Plus Bond ETF | $5.78B | 2.8% | 5.3% | 0.40% | ETF | Yes |
| VPLS | Vanguard Core Plus Bond ETF | $138M | 2.5% | 4.8% | 0.2% | ETF | Yes |
| FIXD | First Trust TCW Opportunistic Fixed Income ETF | $4.32B | 2.1% | 4.3% | 0.65% | ETF | Yes |
| DBND | DoubleLine Opportunistic Bond ETF | $413M | 2% | 4.8% | 0.45% | ETF | Yes |
| DFCF | Dimensional Core Fixed Income ETF | $243M | 2% | 4.6% | 0.19% | ETF | Yes |
| CGCP | Capital Group Core Plus Income ETF | $4.5B | 1.8% | 4.8% | 0.34% | ETF | Yes |
| SRLN | SPDR Blackstone Senior Loan ETF | $9.49B | 1.5% | 7.5% | 0.70% | ETF | Yes |
Overall, the uncertainty and volatility within the Treasury market has them not acting like themselves. The recent debt downgrade underscores the change. Rising uncertainty has made them riskier than before. To that end, bond investors need to get active and look outside the major indices for opportunity.
The Bottom Line
The recent dent downgrade and reaction highlighted just how weird the bond market has been lately. Ultimately, Treasuries are not acting like themselves. To that end, active ETFs and management could be the best fix to avoid many of the troubles with the Agg and Treasury market.
