Investing in bonds: 3 reasons not to go with the flow

08/07/2019

The cheapest way to invest in the global bond market may not always be the most cheerful.

The attraction of so-called passive funds is typically their lower costs. They try to mirror the composition of a given market – bonds issued by governments, for instance – offering you, the investor, a way to get exposure to all of it.

Glossary

For explanations of the investment terms used throughout this article.

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Cost aside, passive funds have pros and cons versus actively managed funds, where investment decisions are made on a case-by-case basis to pursue specific goals, like delivering a growing income for investors. An advantage of passive funds – that they are unlikely to underperform the market by much – is also a disadvantage. There’s little potential to outperform.

If you have chosen to invest in bonds, here are three reasons why we believe you should consider taking an active approach.

1. Pick winners, not sinners

If you’re lending money, would you choose to lend the most to those who are most indebted? This reflects, in short, the reality of investing in bonds – which are ultimately loans to governments or companies – through most passive funds.

Passive funds that track an index of all government bonds will closely reflect the total stock of global government debt. The most indebted countries will be the largest components of such a fund. Likewise, the most indebted companies carry disproportionate weight in funds that track an index of all corporate bonds.

The heavily-indebted governments and companies that will form the most significant constituents of passive bond funds – the ‘sinners’ – may be far from the type of bond issuer that you might prefer to heavily invest your money in.

An active investor can avoid investing in the debt of any government or company that they believe to be over-indebted. They can instead attempt to pick the ‘winners’ on behalf of investors in their fund.

2. Diversify effectively

When it comes to investing in bond funds, it is important to look ‘under the bonnet’ at the underlying assets to check if it is invested in a way that reflects your appetite for risk.

If you are looking for a well-diversified investment, bear in mind that not all bond funds have as extensive a spread of bonds as you might think. This can be especially true of corporate bond funds. The global stock of corporate debt is heavily skewed towards certain countries and industries. This is reflected in many indices for the corporate bond market, and therefore what the passive funds tracking them invest in.

For instance, US companies account for most of the world’s ‘high yield’ corporate debt (bonds issued by companies deemed less likely to repay their bondholders in full), and therefore dominate passive funds that track this part of the market. This may or may not end up leading to better returns for investors, but it will limit the diversification that such a fund can offer alone.

By contrast, an active fund manager can create a portfolio that aims to offer investors a more balanced mix of bonds – reflecting their views, not the current value of assets in that part of the market.

3. Act on opportunities

Whereas passive funds are tied to the stock, sector or regional weightings of a respective bond market index, their active counterparts have more flexibility. Active managers can act on their convictions to take advantage of where they believe bonds are mispriced – buying where an asset is cheap, and selling where one might be deemed expensive.

Active managers can also add value through comparing bonds from similar issuers across currencies or different parts of the market, to spot where certain bonds might be mispriced. Unlike passive funds, they can also invest profit when bonds are first issued, capitalising where they believe there is an opportunity and taking advantage of any discount for investors on day one.

There are a wide range of actively-managed funds that invest in bonds, each with their own specific objective and strategy to achieve it. While some aim to deliver a steady, or perhaps rising, income for their investors, others aim to keep up with inflation, for example.

With such a range of approaches to choose from, one or more funds could resonate closely with your own goals and what you are trying to achieve with your investments.

Important information

The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

The views expressed in this document should not be taken as a recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.