Active bond funds may be poised to stand out as rates fall

Actively managed bond funds put up a strong showing against their passive counterparts in the past year – and they could do it again as the Federal Reserve cuts interest rates. Over the 12-month period ending June, about 2 of 3 active bond managers trounced their average passive counterpart, according to a recent analysis from Morningstar . In particular, the intermediate core bond category — funds that largely invest in investment grade corporates, government bonds and securitized debt — saw a success rate of 72%. There were a few tailwinds in active managers’ favor. For most of that period, the fed funds rate was at a range of 5.25%-5.5%, a dynamic that favored exposure to bonds with less duration – that is, shorter-dated bonds with less price sensitivity to rate fluctuations — and rewarded investors who were willing to take credit risk. “That was the absolute sweet spot for those bonds in that 12-month period, and you saw that show up in the overall results for active bond managers,” said Ryan Jackson, senior analyst of passive strategies at Morningstar. With the Fed recently cutting rates by a half point — and Chair Jerome Powell noting that two more quarter-point cuts could be in the cards this year — a new challenge awaits these active bond funds. “Looking ahead, this nice juicy yield that people have enjoyed – it’s not going to come down to zero, but it will be an interesting time for bond investors,” said Jackson. A nimble approach Passive bond funds tend to have heavier weightings on Treasurys compared to their active counterparts, where you’re more likely to see managers take some credit risk and exposure to bespoke bond holdings, Jackson said. “That market is fragmented and there’s more opportunity for mispricing,” he added. “With that, comes a better chance to exploit that mispricing and deliver returns.” Another plus for active fund managers is the opportunity to exploit market developments. Consider that passive funds are required to buy certain securities to mimic the index they follow, which can result in spread compression for those assets, said Paul Olmsted, senior manager research analyst, fixed income, at Morningstar. “[Active] managers can use that dynamic of the passive funds to avoid some of the securities that might be technically tight and go into the other parts of the market that might not be in the index and offer a little bit better relative value,” he said. As interest rates fall, active managers can position accordingly, said Roger Hallam, global head of rates at Vanguard. “If you were passive and didn’t have the ability to vary your yield curve exposure, you wouldn’t be able to benefit from the Fed’ s attempt to cushion the economic landing,” he said. In particular, Hallam highlighted the core and core-plus bond categories as offering investors a combination of attributes that fare well in challenging times but also provide yield. See below for a list of some of the top performing actively managed bond funds in the 12-month period ending June 30, per Morningstar’s analysis. The Leader Capital Short-Term High Yield Bond Fund (LCCMX) returned of 21.87% in that period, benefiting from a roughly 94% allocation toward floating-rate instruments, and about 98% of its holdings have a duration of less than one year. Both factors fared well in a high interest rate environment and lifted LCCMX to the top of Morningstar’s list among strongest performers in the period. The fund has a 30-day SEC yield that tops 10%, but its costs are also high: total annual fund operating expenses come in at 3.24%, according to LCCMX’s prospectus. Shop with an eye toward quality and cost Morningstar found that even as actively managed intermediate core bond funds beat their passive counterparts, the most successful offerings were those with the lowest expenses. “We expect active managers to make a little more, and they should be because they’re doing more trades and it costs more to manage active portfolios,” said Olmsted. “Prices matter and they come off the [investor’s] bottom line, so you have to look at it from that perspective, too.” Investors should also get familiar with the asset classes that are driving a given fund’s higher yields. A bond fund’s income prospects may be attractive, but it’s all for naught if it suffers in a downturn — and worse still, if it fails to offset the volatility an investor might see on the equities side of the portfolio. “Be careful about risk, especially risk in lower grade credit,” said Olmsted.