Short-dated credit has been high demand in recent years and many retail investors opted for passive funds to gain exposure. But with 2024 almost certainly set for an interest rate cut, there is cause to rethink this passive position and particularly when drilling down into asset classes such as short-dated credit.
"The market has been beta chasing and that is why we have seen the growth of passives in recent years. But now relative value is becoming more and more important because of volatility and higher dispersion. This is where active investors will be able to generate more alpha," says Shamil Gohil, manager of the £496m Fidelity Short Dated Corporate Bond Fund.*
Kris Atkinson, lead portfolio manager on the strategy agrees citing recent economic tailwinds have increased the opportunity set for active managers in short duration greatly. "After a long time, central banks are no longer the influence they used to be. And we are already seeing more dispersion between asset classes and investments on both the credit and equity side. As growth trends lower, it stands to reason that we are going to see more of that, so there are many more opportunities for us to take advantage of now."
Sub-optimal performance?
In a passive approach the fund replicates the benchmark, meaning regular rebalancing, higher turnover and increased transaction costs. Overall, passive funds also tend to underperform indices on a net basis due to these fees. Within short-dated credit this underperformance is even more pronounced and often means passive performance for this asset class can be "sub-optimal".
Furthermore, passives are also beholden to issuance in the market. This is no surprise, but it does mean investors are more exposed to bigger names that tend to have higher leverage, according to Gohil.
"When the market is volatile, we as active investors tend to overweight and underweight, and where there tend to be bargains relative to fundamental quality, we can overweight those names in time. But a passive vehicle owns the market weight by default."
Out of index exposure
Passives are also known for their elevated trading levels, but this is exacerbated in the short-dated market where the fund managers note new bonds are constantly entering and leaving the 1-5-year index as they move towards maturity. As a result, passive funds are forced to buy and sell at either end of the maturity spectrum.
According to Ben Deane, Fixed Income Investment Director at Fidelity, this presents an opportunity for active investors, by being able to take out-of-index exposure.
"If you think about a one- to five-year benchmark that passive funds track, you are restricted to buying 1-year to 5-year bonds. When a bond moves less than 1-year to mature, you are a forced seller," he explains. "This presents a good buying opportunity for active investors. Likewise, active investors can by 5.5-year maturity bonds before they enter the one- to five-year benchmark and therefore benefit from forced passive buying as these bonds fall into the benchmark.
Complex opportunities
Meanwhile, Atkinson explains another area the team can add value via actively managing short duration bonds is in ‘complex' credit, such as asset-backed securities, or opportunities within regulated utilities such as the water sector.
The managers' ability to dig into these sectors and find attractive investments allows them to identify opportunities some fund houses will be less likely to access.
*Source: Fidelity International, as of 31 March 2024.
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Important information
This is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. The value of investments in overseas markets may be affected by changes in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. They can also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations.
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