Latest / The Issue at Hand by Madison Investments / Active or Passive: How to Align Bond Allocations to Investor Goals
Transcript
- speaker-0: I wanna have it as a backup, all right. So we got ten more seconds and then we're started. speaker-1: Just like the spurs back up. speaker-0: ⁓ don't even go ⁓ see now you just threw me off. Now ⁓ that's just messed up. Welcome back to the issue at hand. I'm Chris Solomon. He's Mike Sanders. How you doing, man? speaker-1: Doing well, doing well. How are you? speaker-0: Okay. Well it's ⁓ it's been a it's been a crazy couple of weeks in the bond market since the last time we spoke as rates have kinda gone up. Do you think this is short term fluctuations or do you think there's kind of a shift away from US treasuries? speaker-1: No, I don't I don't think this is a a wholesale shift away from treasuries. you know, there's obviously issues from a fiscal perspective out the curve. I think then that's better reflected in the 30 year than maybe more of intermediate part of the curve. I think when I just looking at pricing and kind of the movements in the market, I think this has been more of a pricing out of Fed fund and you know monetary policy moves and less about long-term inflation changes. If you look at you know five year, five year forward inflation ⁓ markets, kind of one of the Feds ways they look at inflation, it's really been pretty stable. So I think this is just ⁓ a repricing of the of the policy rate and not a a a a a shift, if you will, in like the natural demand for treasuries. speaker-0: Well I guess that's that's reassuring. But do you think this ⁓ you think this ticked up means it's a buying opportunity? speaker-1: Yeah, I think I think it is ⁓ if you look at this kind of the risk reward at these levels of rates, yeah, I do think it's ⁓ it's ⁓ wouldn't be a terrible idea to kind of shift out ⁓ maybe extend duration a little bit. But you know, it obviously depends on your on your needs from a portfolio perspective. speaker-0: 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 should be I 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 at yield and credit positioning? Our goal for this episode is to lay out those risks of each and hopefully identify what works best, I guess, for you and your clients. Right, Mike? speaker-1: Yeah, exactly. There's 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 kind of talk through everything and make sure everybody's at least making informed decisions. speaker-0: Well, I think the important thing also to remember is when we're talking about when I when I say the word indexing, people have to remember that bond indexing is different, it's 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 five hundred, you're owning the biggest, most successful companies. Okay. But bond indexing, you are lending money to companies governments, if you're depending on the strategy, that owe the most money. So I think 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 the and the biggest s is taking on the biggest slice of your investment. Is that fair? speaker-1: Yeah, no, it's a hundred percent right. And it's not that it's good or bad. It's just you have to be aware of you're more 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. speaker-0: 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 with talking about some of the differences a little bit more detailed on the indices, the ladders, and the active strategy? speaker-1: Yeah. So when you choose to go the maybe passive indexed route, you have broad exposure to lots of different parts of the fixed income market. Some of them might be attractively priced, if you will, 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 a right ⁓ asset class within that, you know, fixed income index. It's more about owning everything, good and bad. ⁓ you know. There's usually lower fees when it comes to indexing, which definitely helps in terms of performance. It it generally is gonna follow the general trend in terms of the overall bond market. There's not gonna be a lot of variation in terms of performance over time. You're gonna get what you're gonna get. When you kind of think about a laddered approach, ⁓ again, that's a 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, you know, 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 normally the. Yield curve is positively sloped. And so as a bond matures off or coupon payments are made, ⁓ you can reinvest that out five or ten years, and then you have a higher yielding security than what is kind of rolled off in terms of what you've invested. That's a positive. But 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 one to ten 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, yields could have changed. And so the the the investment decision, the reinvestment decision is really a function of a couple of days after the bond maturity occurred is when that reinvestment's going to happen, not that there's a better opportunity, if you will. speaker-0: And 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 a decision. But I mean, I don't want to say you're locked in, but you're you you're at the mercy of the maturity schedule. Is that fair? Yeah. speaker-1: Exactly. And then again, a a lot of managers they do ladders. ⁓ they there's some overlay of credit research on that as well, munis as well. So it's yeah a lot of muni ladders, a lot of corporate bond ladders are gonna have that active credit research overlay to it. I think another thing that might maybe is a little more nuanced is that you invest in a ladder portfolio from a professional money manager, you're gonna 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 on yourself. So I do think that's that's another maybe a difference to think about in terms of what kind of yield can I get on a on a specific bond purchasing a portfolio of bonds on the latter, doing it you know, individually versus doing it with a manager and then paying a small fee. It's another thing to think about. speaker-0: And then on the active side, I think what we need to touch on is you're you're getting a lot more flexibility. But again, there's built in risks there, right? speaker-1: Yeah, yeah, right. If there's you know, those four risks that we discussed in the last podcast, you know, 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. Yeah. And as long as performance, the earned income is better than the the index subject and then adjusted for the fees, you're you're in a better situation. Yeah, there's you know there's always the the issue though you have to understand how your manager thinks about those risks and how willing they are to allocate to specific risks. Maybe owning, you know, non-typical fixed income asset classes in a bond portfolio that maybe that's not what you want as an al as a as a advisor or an investor. So just being aware of The opportunity set, if you will, for the for the active manager is something that from a risk management perspective, I think you definitely have to understand. You'd want your fixed income to act like fixed income when volatility hits. And 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. Now, on the negative side, they're typically more expensive. speaker-0: Well let's touch on that for a minute. I think when I'm having conversations with advisors, we're typically it it kind of boils down to, Hey, this is the I 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? Yeah. speaker-1: I think only focusing on the cost side, ⁓ sometimes you might lose the the goal of why you're allocating. You know, you can say that over-emphasizing overemphasizing anything, even on managing a portfolio, overemphasizing on the risk perspective can make sure you're not going to take any risk and then your returns are gonna suffer. Only focusing on fees ⁓ when there's a lot of opportunities and fixed income for performance. you're kind of losing sight of the goal of the allocation, in my opinion. So yeah, there there's a balance. Clearly, there's a level of fees that the manager won't be able to to justify. But again, that's that's, you know, do your 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 kind of your goals and expectations. No right or wrong answer. It's just it kind of depends on how you wanna look at the speaker-0: So I 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's up, inflation's up. I think people need to know what they o like we just said, 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? speaker-1: Yeah, I mean I I think again, it's opportunity costs sometimes at fixed income. And so, you know, with yields where they are, there are risks of inflation and you know, cash rates, money market rates, C D rates are all well below four percent, while a lot of the fixed income markets well above five percent. I think just in general, ⁓ It's a great time to kind of looking at the fixed income markets again and and locking in yields that I think are gonna be very attractive over the intermediate term to long term. I mean rates could go higher, they could go lower, nobody really, really knows. But it's about kind of managing that risk and the what's gonna happen if rates go a little bit higher. well, if you locked in the yields and you have a a a a a longer term time frame, it's it shouldn't really matter. Right. Is your benchmark. You you don't want that. You want to look at it from a longer perspective. ⁓ speaker-0: What we want people to understand here, I think, 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 predictable income that I'm kind of locked in at, which would be the ladders? Do I want something with a little flexibility with regard to maturity, yield, 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 gonna 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 the conversations with their clients. Do you have anything to add to that in terms of that breakdown? speaker-1: No, I think that's a good I think that's a good summary of every second. speaker-0: Yeah. Well I hope I hope we've we've ⁓ shed some light on the three different options within active and passive. I think that does it for today. So if you wanna hear more, please don't forget to click subscribe. But for any other information or disclosures you can find them at Madison Investments dot com. Thanks for tuning in.