Active Bond Funds Have Put Up Strong Performances - and Falling Rates May Help Them Stand Out

Actively managed bond funds have recently outperformed their passive counterparts, and this trend could continue as the Federal Reserve adjusts interest rates. Over the past 12 months, ending in June, roughly two-thirds of active bond managers outperformed the average passive bond fund, according to a Morningstar analysis. Specifically, the intermediate core bond category, which includes funds invested in investment-grade corporate bonds, government bonds, and securitized debt, had a success rate of 72%.

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Several factors worked in favor of active managers during this period. For most of the year, the Federal Reserve's interest rate hovered between 5.25% and 5.5%. This environment favored bonds with shorter durations, which are less sensitive to interest rate changes, and rewarded investors who were willing to take on some credit risk.

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Ryan Jackson, a senior analyst for passive strategies at Morningstar, noted that bonds with shorter durations hit the "sweet spot" during the past 12 months, benefiting active bond managers' overall performance. However, the landscape is shifting, with the Federal Reserve recently cutting rates by half a percentage point. Fed Chair Jerome Powell also hinted at the possibility of two more quarter-point cuts later in the year. This evolving environment could present new challenges for active bond managers.

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Jackson cautioned that while bond yields are unlikely to drop to zero, bond investors may face a more complex environment moving forward. Active bond managers are expected to continue leveraging their ability to adapt to market changes, which could give them an advantage over passive funds.

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One key difference between passive and active bond funds is that passive funds tend to have a higher allocation to U.S. Treasury bonds. In contrast, active managers are more likely to take credit risk and invest in less conventional bond holdings. This provides active managers with more opportunities to exploit market inefficiencies, as the bond market is fragmented and presents chances to capitalize on mispricing.

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Jackson explained that active managers can take advantage of these opportunities to deliver better returns, as passive funds are constrained by the need to mirror the indices they track. This requirement often forces passive funds to buy specific securities, potentially leading to spread compression for those assets. Active managers, on the other hand, can avoid these tightly priced securities and instead invest in areas of the market not included in the index, offering better relative value.

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Roger Hallam, global head of rates at Vanguard, emphasized that active managers have the flexibility to adjust their portfolios as interest rates fall, whereas passive funds are locked into their index-based allocations. This adaptability allows active managers to benefit from the Federal Reserve's efforts to soften the impact of an economic slowdown. Hallam pointed out that core and core-plus bond categories offer a combination of yield and attributes that tend to perform well in difficult economic conditions.

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A list compiled by Morningstar highlights some of the top-performing actively managed bond funds over the past year. One standout is the Leader Capital Short-Term High Yield Bond Fund (LCCMX), which posted a 21.87% return during the period. The fund's success was driven by a 94% allocation to floating-rate instruments, with nearly 98% of its holdings having a duration of less than one year. This short duration helped the fund perform well in a high-interest-rate environment, securing its spot at the top of Morningstar's rankings.

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However, it's important to note that LCCMX's impressive returns come at a cost. The fund's total annual operating expenses are 3.24%, which is relatively high, although its 30-day SEC yield is over 10%. Investors should weigh these costs against the potential returns when considering actively managed bond funds.

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Morningstar's analysis also found that the most successful actively managed intermediate core bond funds tended to have lower expenses. Paul Olmsted, senior manager research analyst at Morningstar, pointed out that while active managers are expected to deliver higher returns because they trade more frequently and incur higher management costs, fees still matter. These costs can eat into investors' returns, making it essential to consider a fund's expense ratio when evaluating its potential.

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In addition to considering costs, investors should be mindful of the asset classes driving a bond fund's yields. High yields may be appealing, but they are only beneficial if the fund can withstand market downturns. It's particularly crucial to ensure that a bond fund can offset volatility in other areas of a portfolio, such as equities.

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Olmsted also cautioned investors to be wary of lower-grade credit risks. While such investments may offer higher yields, they can carry significant risks, especially in times of market stress. Investors should approach these opportunities with care and a clear understanding of the risks involved.

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In conclusion, actively managed bond funds have shown resilience in the past year, outperforming their passive counterparts. With the Federal Reserve continuing to adjust interest rates, active managers may be well-positioned to navigate the evolving market environment. However, investors must remain vigilant about costs and risks to maximize their returns.

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