The Issue at Hand by Madison Investments
When does it make sense to use active management over bond ladders or index funds? And how should investors think about the tradeoff between fees, flexibility, and risk management?
In this episode, Chris Aleman and Mike Sanders explore the debate around active versus passive fixed income investing. The discussion breaks down the tradeoffs between each approach, including duration exposure, reinvestment risk, credit quality, liquidity, flexibility, fees, and the hidden risks embedded in bond indexes. We also explain why fixed income indexing differs fundamentally from equity indexing.
Whether your preference is active management, bond ladders, or passive exposure, understanding the risks behind each approach can lead to more informed portfolio construction decisions and better long-term outcomes.
Key Takeaways
- Bond indexing differs from equity indexing because fixed income indices allocate more heavily toward the largest issuers of debt
- Passive indexed, laddered, and active bond strategies involve different tradeoffs in flexibility, risk, reinvestment timing, and fees
- Laddered portfolios can provide structure and predictable income, but flexibility is limited by maturity schedules
- Active fixed income strategies offer more flexibility across duration, yield, and credit positioning, but investors should understand the risks within the strategy
- Focusing only on fees may overlook important differences in risk management and long-term return potential
The Discussion
Chris Aleman: Welcome back to The Issue at Hand. I’m Chris Aleman, and he’s Mike Sanders. How you doing, man?
Mike Sanders: Doing well, doing well. How are you?
Chris Aleman: It’s going okay! Well, it’s been a crazy couple of weeks in the bond market since the last time we spoke, as rates have gone up. Do you think this is short-term fluctuations or do you think there’s a shift away from US Treasuries?
Mike Sanders: No, I don’t think this is a wholesale shift away from treasuries. There’s obviously issues from a fiscal perspective out the curve. I think that it’s better reflected in the 30-year than maybe the more intermediate part of the curve. Just looking at pricing and the movements in the market, I think this has been more of a “pricing out of Fed fund and monetary policy moves” and less about long-term inflation changes. If you look at five-year, five-year forward inflation markets, one of the ways the Fed looks at inflation, it’s really been pretty stable. So I think this is just a repricing of the policy rate and not a shift in the natural demand for treasuries.
Chris Aleman: Well, I guess that’s reassuring. But do you think this ticked up means it’s a buying opportunity?
Mike Sanders: Yeah, I think it is. If you look at the risk-reward at these levels of rates, yeah, I do think it wouldn’t be a terrible idea to shift out, maybe extend duration a little bit. But it obviously depends on your needs from a portfolio perspective.
Chris Aleman: Yeah, of course. All right, well, now that we’ve gotten that out of the way, let’s get down to what we wanted to discuss today.
So today, we’re talking active and passive bond strategies. What we’re trying to talk about is the questions that advisors and clients should be asking when deciding between the two. Do I simply want to own the entire market? Do I want something where I collect a coupon and reinvest the bond maturities? Or do I want something with a little more flexibility and duration, yield, and credit positioning?
Our goal for this episode is to lay out those risks of each and hopefully identify what works best for you and your clients. Right, Mike?
Mike Sanders: Yeah, exactly. There’s no bad strategy or good strategy. It’s all dependent on what your goals are, and kind of maybe even the market environment. So, we’re here just to talk through everything and make sure everybody’s at least making informed decisions.
Chris Aleman: Well, I think the important thing also to remember is when we’re talking about – when I say the word indexing, people have to remember that bond indexing is not the same as equity indexing. On the equity side, you own the biggest, most successful companies. I guess if anybody needs to use a real-world example, let’s look at SPY. You’re owning the S&P 500, you’re owning the biggest, most successful companies.
But bond indexing, you are lending money to companies, governments, depending on your strategy, that owe the most money. So one of the things that I wanted to make sure – this isn’t talking bad about it, it’s just to make sure that everybody understands – when you are going into an index strategy, you are going after the biggest debtor and are taking on the biggest slice of your investment. Is that fair?
Mike Sanders: Yeah, no, it’s 100 % right. And it’s not that it’s good or bad, it’s just you have to be aware of how you’re more exposed to, in theory, higher leveraged entities, corporates, governments, etc. And sometimes there’s value there, and sometimes there isn’t value there. It just really depends on the environment.
Chris Aleman: Yeah, so that makes sense. I think what we want to do now is lay this out in the framework of those three choices. So Mike, why don’t you start us off by talking about some of the differences, a little bit more detailed, on the indices, the ladders, and the active strategy?
Mike Sanders: When you choose to go the passive indexed route, you have broad exposure to lots of different parts of the fixed income market. Some of them might be attractively priced in terms of yield, some of them might be unattractively priced when it comes to yield. But it’s really not a decision in terms of attractiveness of an asset class within that fixed income index; it’s more about owning everything, good and bad. There are usually lower fees when it comes to indexing, which definitely helps in terms of performance. It generally follows the general trend in terms of the overall bond market. There’s not going to be a lot of variation in terms of performance over time – you’re going to get what you’re going to get.
When you think about a laddered approach, again, that’s somewhat passive in the context of there’s not really trading in between the implementation of the ladder. Meaning that you invest in a ladder, the manager might buy bonds from one year out to 10 years out, let those mature down, roll down the curve, if you will, mature, and then the reinvestment occurs. That is good and bad. I think the good on that is that normally the yield curve is positively sloped. And so, as a bond matures off or coupon payments are made, you can reinvest that out 5 or 10 years, and then you have a higher-yielding security than what is rolled off in terms of what you’ve invested, and it’s a positive.
On the same token, if you will, it’s negative because you don’t have consistent exposure to the asset class, right? If you buy a 1-to-10-year corporate bond ladder, you have an average maturity of, let’s say, five years for the sake of argument. And then by the time your first reinvestment occurs, it’s going to be a four-year portfolio. And so, the markets could have changed, spreads could have changed, and yields could have changed. So the reinvestment decision is really a function of a couple of days after the bond maturity occurred is when that reinvestment is going to happen, not that there’s a better opportunity, if you will. That’s the difference.
Chris Aleman: I think that kind of blends what you were talking about with it is passive because you can’t really do anything until it matures – there is some active side because the manager does have to make the decision. But I mean, I don’t want to say you’re locked in, but you’re at the mercy of the maturity schedule. Is that fair?
Mike Sanders: Yeah, exactly. And then again, a lot of managers that do ladders, there’s some overlay of credit research on that as well – munis as well. So, a lot of muni ladders, a lot of corporate bond ladders are going to have that active credit research overlay to it. I think another thing that maybe is a little more nuanced is that if you invest in a ladder portfolio from a professional money manager, you’re going to get institutional-level pricing on those securities, and they may or may not be better. Well, a lot of times they will be better than maybe the prices that you could get on an individual bond basis, just buying them by yourself. So, I do think that’s another difference to think about in terms of, “what kind of yield can I get on a specific bond purchase in a portfolio of bonds in a ladder?” Doing it individually versus doing it with a manager and then paying that small fee. It’s another thing to think about.
Chris Aleman: And then on the active side, I think what we need to touch on is, you’re getting a lot more flexibility. But again, there are built-in risks there, right?
Mike Sanders: Yeah, if there are those four risks that we discussed in the last podcast, an active manager gets to look at all those risks and allocate to maximize the total return potential of that portfolio. And so, that’s what you’re paying for, that’s the alpha, if you will. And as long as performance, the earned income is better than the index and then adjusted for the fees, you’re in a better situation.
There’s always the issue, though, that you have to understand how your manager thinks about those risks and how willing they are to allocate specific risks. Maybe owning non-typical fixed income asset classes in a bond portfolio, maybe that’s not what you want as an advisor or an investor. So just being aware of the opportunity set for the active manager is something that, from a risk management perspective, I think you definitely have to understand you want your fixed income to act like fixed income. When volatility hits, the last thing you want to do is see parts of your fixed income portfolio acting like equities when it’s supposed to be protecting other parts of your portfolio. So that’s something to think about.
On the negative side, they’re typically more expensive.
Chris Aleman: Let’s touch on that for a minute. I think when I’m having conversations with advisors, it typically boils down to, “hey, I’m balancing yield and fees. I’m trying to usually just go after the cheapest option”. I feel like that’s a little misleading in terms of just thinking about fees. Is that fair?
Mike Sanders: Yeah, I think only focusing on the cost side, sometimes you might lose the goal of why you’re allocating. You could say that over-emphasizing, even on managing a portfolio, over-emphasizing on the risk perspective can make sure you’re not going to take any risk, and then your returns are going to suffer. Only focusing on fees, when there are a lot of opportunities in fixed income for performance, you’re losing sight of the goal of allocation, in my opinion. So there’s a balance clearly, there’s a level of fees that the manager won’t be able to justify, but again, do your research, do your reviewing of how managers think about the world in terms of how you personally view the market, how you personally view a fixed income allocation, the goals of your clients, etc. So again, regardless of the strategy, it’s really about making sure everything’s matching up with your goals and expectations. There’s no right or wrong answer. It just depends on how you want to look at the problem.
Chris Aleman: I like that. So, let’s put that in terms of today’s backdrop. I mean, rates have climbed up pretty fast over the last couple of weeks. Volatility is up, inflation is up. I think people need to know what they own in their selections. But what does that mean right now in terms of a fixed income allocation for clients? Does that make sense?
Mike Sanders: Yeah, I think it’s opportunity costs sometimes in fixed income. So, with yields where they are, there are risks of inflation, and cash rates, money market rates, and CD rates are all well below 4%, while a lot of the fixed income markets are well above 5%. I think just in general, it’s a great time to – looking at the fixed income markets again and locking in yields that I think are going to be very attractive over the intermediate term to long term. Rates could go higher, they could go lower – nobody really, really knows, but it’s about managing that risk. And what’s going to happen if rates go a little bit higher? Well, if you’ve locked in the yields and you have a longer-term timeframe, it shouldn’t really matter.
You don’t want to be making investment decisions in and out of an asset class with very, very short periods of time as your benchmark. You don’t want that. You want to look at it from a longer perspective.
Chris Aleman: I think what we want people to understand here is that in looking at these strategies, at the end of the day, you need to see what you and your client have an appetite for.
Do I want something in predictable income that I’m kind of locked into, which would be the ladders? Do I want something with a little flexibility with regard to maturity, yield, and credit, but takes on a little bit more risk? Or do I not want to think about any of that at all, but I’m going to own the majority of the largest debtors in the market?
I think that’s one of the things that we want people to understand when they’re having conversations with their clients. Do you have anything to add to that in terms of that breakdown?
Mike Sanders: No, I think that’s a good summary of everything.
Chris Aleman: Well, I hope we’ve shed some light on the three different options within active and passive. I think that does it for today. So, if you want to hear more, please don’t forget to click subscribe. But for any other information or disclosures, you can find them at madisoninvestments.com. Thanks for tuning in.