A Time for Active Fixed Income

The bond market has been on edge to start the year due to stickier-than-expected inflation that has triggered higher-for-longer interest rate expectations. Investors appear to be preoccupied with a wave of tariffs and trade wars, as well as tax cuts and deficits. It has been a perplexing period for investors as U.S. Treasury yields rose (bond yields and prices move in opposite directions) despite the U.S. Federal Reserve’s (Fed) cutting interest rates for the first time in three years.

Despite these tenuous conditions, actively managed bond funds accumulated $261 billion in 2024, which was the highest level since 2021.[1] Market volatility and the inability to react by passive strategies during uncertain times have reinforced the importance of active decision-making. It also supports our belief that passive/index investing tracks yesterday’s investment world while investing tends to be more forward-looking. We believe the current environment of heightened uncertainty, interest rate volatility, and evolving credit risks creates a landscape where skilled active managers have a greater opportunity to add value.

Inflation and Interest Rates: Sticky and Adaptability

Inflation is a large part of the Fed’s monetary policy decisions to raise, lower, or stand pat with interest rates. It has been particularly sticky as of late — as it has risen above the Fed’s target of 2% — causing the Fed to pause further rate cuts for the time being. There have even been murmurs recently of stagflation, which occurs when economic growth slows, unemployment rises, and inflation remains high. This financial condition was last seen in the 1970s during the oil crisis when crude oil prices spiked, interest rates were low, and budget deficits were high. Looking back, inflation rose after some initial success at keeping it in check, which is similar at the onset to what’s happened recently.

[1] Source: Morningstar Direct, as of 31 December 2024.

Inflation Historical Comparison: Back to the 1970s

Past performance does not guarantee future results. Source: Bloomberg, as of 31 December 2024.

Absolute bond yields are appealing, and real yields are at their highest levels since 2007. Bonds have also become attractive for investors with exposure to equities, which have traded at lofty valuations. We believe the current interest rate environment requires a more agile and flexible approach, which we believe is well-suited for active fixed income. Active managers can benefit from this uncertain environment since volatility often equals opportunity, creating the ideal conditions to exploit mispricing. Active investors can gain exposure to areas of the fixed income market not addressed in a passive wrapper. Experienced active managers possess the proficiency to search across market silos and capital structures to identify the most optimal fixed income investment opportunities.

Key Active Benefit: Alpha Generation

The goal of active bond management is to outperform a benchmark/index by uncovering security mispricing, foreseeing interest rate movements, and vigilantly managing credit risk. Active managers can tailor portfolios to meet specific investor needs and objectives, such as income generation, capital preservation, or specific risk constraints. Active can adjust to volatility, changing security fundamentals and market conditions, while passive cannot, which means that what you see is what you get. An active manager’s ability to manage duration, credit risk, sector allocation, and liquidity can be vital in navigating these challenges and potentially outperforming passive benchmarks. The increased dispersion provides active managers more opportunities to find value and add alpha.

Equity markets are generally more efficient than bond markets, which translates into the potential mispricing of fixed income risk. This creates opportunities for active managers to leverage deep fundamental research to assess the fair value of a security. Passive index methodologies dictate that the largest constituents in benchmarks are those issuers with the most debt. This means that the most indebted, potentially most vulnerable issuers are also the most impactful on index performance. Passive investors need to be aware of concentration risks as well as the acceleration of market selloffs and recoveries since the financial crisis.

The Rising Importance of Flexibility in Managing Portfolios

Source: Bloomberg, as of 31 December 2024.

Passive managers buy and hold a security, unable to react to information about either company prospects or market conditions. Investing based on that fundamental information should logically benefit active managers. You can view just about any crisis where the market experienced extreme stress, and the takeaway would be that there was little or no protection on the downside for passive/benchmarks. While passive investing is limited to benchmark-driven strategies, investors who target an active approach are not limited and can access a global universe of assorted opportunities. Our active approach is global and quite flexible. We search across market silos and capital structures to identify the most optimal fixed income investment opportunities for our clients, focusing on securities that offer compelling fundamentals, relative value, and diversified portfolio risk exposure.

Targeted Risk Management During Volatility

Market volatility, as measured by the CBOE Volatility Index (VIX), has risen significantly in 2025, and the bumpy road has been present since mid-2024. For context, the VIX measures the implied volatility of the S&P 500^® Index for the following 30 days, and the readings generally correlate to:[2]

• 0-15, low volatility
• 15-20, moderate volatility
• 20-25, medium volatility
• 25-30, high volatility with market turbulence
• 30+, extremely high volatility

[2] Source S&P Dow Jones Indices, What is VIX and What Does it Measure?

Volatility Has Accelerated

Source: Bloomberg, CBOE Volatility Index (VIX) as of 11 March 2025.

Persistent volatility tends to erode investor confidence, driving apprehension and, at times, panic. This emotional reaction leads to a fervent desire to protect on the downside. We structure portfolios for downside protection while seeking to optimize risk-adjusted returns. Throughout the investment process, we focus on securities that offer compelling fundamentals, relative value, and diversified portfolio risk exposure. We manage risk within our active portfolios through qualitative portfolio manager peer review and quantitative techniques, which provide abundant data on factor exposures, credit, interest rates, and volatility metrics. Investment risk is analyzed through intensive, bottom-up fundamental analysis and valuation for individual investments.

The Case for Active

Active management is particularly well suited for the complexity and sheer magnitude of the bond market, which is less transparent than the equity market, so experienced active managers can identify mispricing and credit risks. Active managers can take advantage of concessions when new bonds are issued, while passive strategies typically must wait until the bond is included in an index. In times of market stress, active managers can be more selective about the bonds they sell to meet investor redemptions. This can help minimize losses during periods of heightened volatility or illiquidity. Many bonds trade infrequently, unlike highly liquid stocks, and active managers can potentially find undervalued securities or avoid forced selling during market downturns.