Bonds: Why Active?

Conditions Are Ripe For Skilled Active Bond Managers

When it comes to bond markets, Harbor believes active managers have a clear long-term edge over indexes. The construction rules for fixed-income benchmarks are inherently flawed because they place the greatest weight on those issuers with the most debt. Active managers can gain an advantage over indexes through detailed credit research, which helps them avoid fundamentally unsound issuers burdened by too much debt, and instead favor issuers with the financial strength to comfortably service their debt over time.

Granted, the bond market currently faces high levels of uncertainty, but that bolsters the case for active management, in our view. Volatility in the bond market has soared over the past several months, as fixed-income investors have contended with surging inflation, rising interest rates, and sporadic banking crises, among other challenges. The chart below, which plots the rolling 1-year standard deviation for the Bloomberg US Aggregate Bond Index over the last decade, shows just how dramatically volatility has spiked in response to investors’ increasing concerns.

Source: Morningstar Direct, March 2023

While the recent turbulence can be difficult for some to stomach, it’s an environment that can play into the hands of experienced active managers. Volatility leads to mispricing’s, presenting the opportunity for portfolio managers to acquire fundamentally sound bonds at attractive prices. Managers with robust investment processes and many years’ of experience navigating credit cycles can keep a cool head and carefully sift through the opportunity set to make informed security-by-security decisions.

Another indication of improving conditions for active managers is increasing dispersion among investment grade bonds. The chart below shows the difference between the bottom 25 bonds and the top 25 bonds in the Bloomberg US Aggregate Index. As you can see, the spread has widened significantly so far in 2023.

Source: FactSet, March 2023

When dispersion is low, the performance of the underlying securities in the index are similar, providing fewer opportunities for active managers to distinguish themselves. In contrast, when dispersion is high, there are more opportunities for talented active managers to add value by applying their skill and informed judgment to identify the winners and avoid the losers.

We believe that these conditions—rising volatility and dispersion— have come about because the bond market is in the midst of a regime change. With the Fed continuing to ratchet rates higher in its ongoing battle against inflation, the days of ultra-low interest rates are likely behind us, in our view. Uncertainty and volatility may continue as investors grapple with this new reality. In this environment, we believe investors are best served by veteran active managers with the capability to carefully scrutinize the universe through rigorous fundamental research and careful, bond-by-bond security selection.

Important Information

The views expressed herein may not be reflective of current opinions, are subject to change without prior notice, and should not be considered investment advice or a recommendation to purchase or sell a particular security.

There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. Stocks of mid cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.

The Bloomberg US Aggregate Bond Index is an unmanaged index of investment-grade fixed-rate debt issues with maturities of at least one year. This unmanaged index does not reflect fees and expenses and is not available for direct investment.

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