Active Versus Passive BondManagement

Active Versus Passive Bond Management

By Benoit Durocher, executive vice-president and chief economic strategist, Addenda Capital.

If there ever was a year to shake your beliefs in indexing, it certainly was 2008. Returns by issuers in the Canadian fixed income world varied widely. Indeed, any security with a hint of credit was disregarded in favour of the safety of Government of Canada bonds. Even federal government agency bonds, fully and explicitly guaranteed by the federal government, suffered to some extent due to reduced liquidity. The huge return gap between Government and corporate bonds certainly provided active managers with the opportunity to outperform the index in 2008.

In addition to duration and yield curve management, active management offers the opportunity for higher returns through security selection and portfolio allocation to credit securities (provincial and corporate bonds). Opting for the passive management of corporate bonds also carries unrewarded risks, as investors hold most of the securities that are included in the index. This approach disregards fundamental credit research as well as the securities’ ranking in the capital structure of the issuer, thus exposing investors to weaker securities that have a higher risk of default or downgrade. Furthermore, higherquality securities that are not in the index are excluded, limiting the potential for value added and diversification benefits. Finally, active managers can respond to market conditions to structure the corporate portfolio differently than the index from a credit rating perspective.

Corporate credit is only one among several sources of value added used by active managers. The movement in benchmark bond yields also offers active managers the opportunity to outperform the index by managing portfolio duration. By efficiently managing duration, the portfolio manager can take advantage of the dispersion of returns by maturity. For instance, in 2008, such opportunities were illustrated by the returns posted by the DEX Government of Canada Mid Term index and Short Term Indices of (+14.92%) and (+9.97%) respectively.

As the 2008 returns for Government of Canada bonds attest, the yield curve may be skewed by structural or fundamental changes, and this can create attractive investment opportunities. Provincial bonds also offer attractive spreads without the credit risk that accompanies corporate bonds and again, due to liquidity constraints and a general flight to quality in the fourth quarter of 2008, provincial bonds offered historically high yields relative to Government of Canada issues. In essence, in an everchanging environment, active managers must adapt their investment strategy to prevailing market conditions in order to generate alpha.



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