Smart strategies for outperformance in fixed income | Insight Investment

“Fixed income markets are less efficient and transparent than equity markets, providing greater scope for active management. The greater the flexibility the manager has, the more potential they have to search out opportunities.”

We outline seven strategies skilled active managers can use when seeking to generate excess returns relative to benchmarks:

• Duration and yield curve: Positioning based on yield outlook or yield curve shape
• Security selection: Identifying undervalued securities with strong fundamentals
• New-issue premia: Capitalising on new debt being issued at above market yields
• Exploiting market fragmentation: Seeking opportunities that stem from the fragmented nature of bond issuance
• Sector strategy: Seeking out those sectors that offer the best opportunity or avoiding those at risk
• Beta management: Adjusting credit risk exposures to take advantage of expected trends in credit markets
• Relative value: Exploiting value differences across markets

Investors in fixed income should be aware of the limitations of traditional fixed income indices when following a passive investment strategy.

Unlike equity indices, which favour the largest and most successful companies, fixed income indices are skewed towards entities with the most debt. The dominance of BBB-rated corporates in investment grade indices further compounds the challenge, increasing the risk of downgrades during economic stress which may force passive investors to sell at inopportune times.

When combined with fees and transaction costs, we believe these factors leave many passive strategies doomed to structurally underperform.

Of course, not all investors seek return maximisation – some just want safe, reliable cashflows. Active managers can improve returns by avoiding defaults and credit deterioration, focusing on credits with strong or improving fundamentals and building diversified portfolios.