Active Management's Edge in Fragmented Bond Markets - Episode Hero Image

Active Management's Edge in Fragmented Bond Markets

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Original Title:

TL;DR

  • The bond market's extreme fragmentation and numerous security varieties necessitate active management, unlike stocks, as each bond can have unique features impacting credit and yield.
  • Active bond managers can exploit market inefficiencies by identifying and capitalizing on less-understood or complex securities, generating consistent, albeit gradual, outperformance over time.
  • Derivatives like credit default swaps and futures offer flexible tools for bond investors to gain exposure or manage risk, enabling them to exploit price discrepancies between synthetics and actual bonds.
  • Indexing in fixed income can expose investors to unintended risks, such as overconcentration in highly indebted companies or increased interest rate sensitivity due to shifts in market composition.
  • Private debt, particularly direct lending, is characterized by illiquidity and often classified as Level 3 assets, requiring manual valuation and posing unique challenges for retail investors.
  • Semi-liquid funds holding private debt have restrictions on redemptions, meaning investors cannot access their capital on demand and must be comfortable with extended lock-up periods.
  • The rise of private debt markets, less regulated than traditional banking, creates potential for hidden interconnections and transmission linkages that can lead to unforeseen systemic risks.

Deep Dive

The bond market fundamentally differs from the stock market, making active management a more effective strategy due to its inherent fragmentation and complexity. This fragmentation creates inefficiencies that skilled active managers can exploit for consistent, long-term outperformance, a stark contrast to the efficiency often found in equity markets where passive indexing can be highly successful.

The bond market's complexity arises from the sheer variety of instruments, even within the same issuer, each with unique features like call provisions that alter risk and return profiles. This necessitates deep expertise, making it challenging for passive indexes to capture the nuanced value that active managers can uncover. For instance, during periods like the European debt crisis or the auto industry's increase in indebtedness in the 2000s, bond indexes became disproportionately exposed to struggling companies like GM and Ford, which ultimately led to bankruptcies and losses for index investors. Active managers, conversely, could identify these risks and minimize exposure, avoiding significant drawdowns. Furthermore, shifts in market composition, such as increased Treasury issuance post-2008 or corporations issuing longer-term debt, have fundamentally altered the interest rate sensitivity of broad bond market indexes, potentially exposing investors to more risk than they anticipate.

The growing landscape of private debt and credit presents both opportunities and challenges for investors, particularly regarding liquidity and transparency. While strategies like direct lending to middle-market companies are inherently illiquid, often classified as Level 3 assets requiring manual valuation, other forms of private debt, such as asset-backed finance, can be structured and securitized to offer greater liquidity and be priced using observable inputs (Level 2 assets). However, investors in semi-liquid funds, interval funds, or BDCs must understand that liquidity is restricted, with redemption windows and potential limitations on returning capital during market stress. This lack of transparency and potential for unforeseen interconnected risks within lightly regulated private markets means investors must be exceptionally diligent in understanding the underlying assets, the vehicle's structure, and the manager's track record, favoring experienced managers with established processes who avoid undue risk.

The core takeaway is that while passive investing has a place in high-quality, liquid segments of the bond market, the inherent fragmentation, complexity, and evolving nature of fixed income, especially in private markets, create persistent inefficiencies. These inefficiencies provide a durable edge for skilled active managers who can navigate the intricate landscape, but necessitate a keen awareness of liquidity, transparency, and structural risks for investors.

Action Items

  • Audit bond market fragmentation: Identify 3-5 sectors with significant inefficiencies and complexity for active management opportunities.
  • Evaluate private debt structures: Analyze 2-3 common semi-liquid fund structures (interval, tender offer, BDC) for liquidity risks and investor suitability.
  • Track asset-backed finance deals: Monitor 5-10 securitized asset-backed finance deals to assess their liquidity and fair value (Level 2 vs. Level 3).
  • Assess active manager toolkit: Review 3-5 derivative instruments (e.g., credit default swaps, options on swaps) used by active bond managers for efficiency and risk control.
  • Analyze corporate debt trends: Examine 3-5 highly indebted corporate sectors to identify potential risks for inclusion in bond indexes.

Related Episodes

Key Quotes

"The bond market is extremely fragmented. It's got multiple sectors and subsectors. You know, one thing I would just say is sort of a cornerstone to the point is this: When you look at stocks, we're generally talking about common stocks, right? A common stock is a common stock is a common stock. In terms of structure, it is the sort of base fundamental unit of ownership for a public company. Bonds, even from the very same company, can have dozens of varieties or even more potentially."

Eric Jacobson argues that the fundamental structure of the bond market differs significantly from the stock market. Jacobson highlights that unlike common stocks, which represent a uniform unit of ownership, individual bonds from the same company can have numerous variations, making them less standardized. This inherent complexity and fragmentation, Jacobson explains, create opportunities for active management.

"The central reason that I think it's important to understand that active investing in bonds can work well is that overall the bond market is extremely fragmented. It's got multiple sectors and subsectors. You know, one thing I would just say is sort of a cornerstone to the point is this: When you look at stocks, we're generally talking about common stocks, right? A common stock is a common stock is a common stock."

Jacobson emphasizes that the fragmented nature of the bond market, with its numerous sectors and subsectors, is a primary driver for the effectiveness of active investment strategies. He contrasts this with stocks, where the concept of a "common stock" is relatively uniform, suggesting that the complexity in bonds provides more avenues for skilled managers to exploit inefficiencies.

"The best thing you can do probably is try and find things to do in the marketplace that are what we might call structural trades. Areas of the bond market that there are generally either inefficiencies that are sort of common to that area that because of some of the things I talked about whether it's areas that investors tend not to go to for example."

Jacobson suggests that successful active bond managers should focus on "structural trades," which involve identifying and capitalizing on inefficiencies within specific areas of the bond market. These inefficiencies often arise in segments that are less frequented by typical investors due to complexity or other factors, creating opportunities for those who know where to look.

"The bottom line is, is that if you are not charging too much money and you have good competent and not overly aggressive management on the bond side, generally speaking, you can outperform indexes reasonably well over periods of time as long as you're dealing with areas of the bond market that have inefficiencies."

Jacobson posits that active bond managers can achieve outperformance relative to indexes if they manage costs effectively and employ competent, measured strategies. He specifies that this outperformance is most likely when focusing on market segments that exhibit inefficiencies, implying that not all areas of the bond market are equally conducive to active management success.

"The problem if you've got some sort of fund with lots and lots of level three exposure is that tells you that there's a lot less transparency there. It also tells you that whatever prices they're using may have to be done somewhat manually and they may not compare perfectly to the prices that somebody else would put on them."

Jacobson explains that a high allocation to Level 3 assets within a fund indicates reduced transparency and reliance on manual valuation methods. He notes that these manually determined prices may not align with what other market participants would assign, suggesting potential issues with liquidity and price discovery for such assets.

"The bottom line is, when you have risk in financial markets, especially when there's fixed income involved, there are connections and what they call transmission linkages that are really, really hard to see because the information is not public. You don't know what the relationships are sometimes between these companies."

Jacobson highlights the inherent difficulty in understanding the interconnectedness of risk within financial markets, particularly in fixed income. He points out that the lack of public information about relationships between entities makes it challenging to identify and assess these "transmission linkages," which can lead to unforeseen consequences.

Resources

External Resources

Books

  • "The Entire Face of the Bond Market Has Changed" by Eric Jacobson - Mentioned as a paper published by the guest discussing active fixed-income management.

Articles & Papers

  • "The Bond Market is Fertile Ground for Active Management" (Morningstar) - Discussed as the primary paper authored by Eric Jacobson that forms the basis of his arguments about active management in fixed income.

People

  • Eric Jacobson - Guest, Senior Principal for Fixed Income Strategies on Morningstar's Manager Research Team.
  • Dan Lefkovitz - Host, Strategist at Morningstar Indexes.
  • Christine Benz - Host of The Long View podcast, wrote an article about investors' tactical approach to fixed income.
  • Bill Gross - Legendary fixed income investor at PIMCO, mentioned for his past success and occasional mistakes in interest rate betting.
  • Dan Fuss - Legendary fixed income investor at Loomis Sayles, described as giddy about investment markets during the 2008 financial crisis.
  • David Bowie - Mentioned as an example of someone who securitized his record catalog royalties.
  • Warren Buffett - Mentioned as an example of an investor with a similar mindset to Dan Fuss during market downturns.

Organizations & Institutions

  • Morningstar - Employer of the guest and host, provides manager research and index services.
  • Temper Financial Services - Previous employer of Eric Jacobson.
  • University of Wisconsin Madison - Alma mater of Eric Jacobson.
  • PIMCO - Asset management firm mentioned for its involvement in private deals and securitized markets.
  • Loomis Sayles - Investment firm where Dan Fuss is a legendary fixed income investor.
  • Blackstone - Private equity firm involved in lending money to companies.
  • KKR - Private equity firm involved in lending money to companies.
  • Carlyle - Private equity firm involved in lending money to companies.
  • State Street - Partnered with Apollo on an ETF (ticker PRIV) focused on private credit.
  • Apollo - Partnered with State Street on an ETF (ticker PRIV) focused on private credit.
  • SSGA (State Street Global Advisors) - Mentioned in relation to their private credit ETF.
  • Financial Accounting Standards Board (FASB) - Sets accounting standards for fair value levels.
  • SEC (Securities and Exchange Commission) - Mentioned in the context of private deals not being registered with them.
  • Federal Reserve (Fed) - Mentioned in relation to monetary policy and interest rates.
  • Treasury - Mentioned in relation to government borrowing and policy.

Tools & Software

  • Think or Swim - Trading platform mentioned as powering Schwab's trading services.

Websites & Online Resources

  • schwab.com/trading - Website to learn more about Think or Swim.
  • thelongview@morningstar.com - Email address for feedback and guest ideas for the podcast.

Other Resources

  • Private Debt - Term for debt originated or issued by a non-bank actor.
  • Private Credit - Term generally referring to direct lending to middle-market companies by non-bank institutions.
  • Direct Lending - Lending set up by large money managers for mid-size and smaller companies.
  • Asset Backed Finance - A way to take a pool of assets that generate cash flows and build a security around it.
  • Asset Backed Securities (ABS) - Securities backed by a pool of assets.
  • Commercial Mortgage Backed Securities (CMBS) - Securities backed by a pool of commercial mortgages.
  • Collateralized Loan Obligations (CLOs) - A type of securitization that pools together various loans.
  • Non-Agency Mortgages - Mortgage-backed securities not issued by government-sponsored enterprises.
  • Level 1 Assets - Assets that are easily priced because they are exchange-traded.
  • Level 2 Assets - Assets not traded on exchanges but can be priced using readily available inputs.
  • Level 3 Assets - Assets that cannot be valued with readily observable inputs, requiring manual pricing.
  • Interval Funds - A type of fund that offers periodic liquidity to investors.
  • Tender Offer Funds - Similar to interval funds, offering periodic liquidity.
  • Business Development Companies (BDCs) - Companies that invest in small and medium-sized businesses.
  • Option Income Funds - A type of gimmicky bond fund designed to generate yield.
  • Cross Hedging Currencies - A strategy used in some bond funds to gain an advantage.
  • Closed-End Funds - A type of investment fund that trades on stock exchanges like stocks.
  • Mutual Funds - A type of investment fund that pools money from many investors.
  • ETFs (Exchange Traded Funds) - Funds that trade on stock exchanges.
  • Securitization - The process of pooling various types of contractual debt (e.g., mortgages, auto loans) and selling their related cash flows to third-party investors as securities.
  • Credit Default Swaps (CDS) - A financial derivative that allows an investor to "swap" or offset their credit risk with that of another investor.
  • Treasury Bonds - Debt securities issued by the U.S. government.
  • Corporate Bonds - Debt securities issued by corporations.
  • Mortgage Market - The market for mortgage-backed securities.
  • Euro Crisis - A period of sovereign debt crisis in the Eurozone.
  • Automobile Debt - Debt issued by automobile manufacturers and suppliers.
  • 2008 Financial Crisis - A major global financial crisis that occurred in the late 2000s.
  • TARP (Troubled Asset Relief Program) - A U.S. government program established by the Emergency Economic Stabilization Act of 2008 to stabilize the country's financial system.

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