Fixed income market overview
While the stage is set for stronger growth in Corporate
America, the turn hasn’t happened yet. The U. S. Federal
Reserve’s (Fed) series of interest rate cuts in 2019 was a
reaction to slowing economic growth both in the U.S. and
China, reduced business spending, plateauing corporate
earnings growth and anticipation of instability driven by
the trade war.
Manufacturing continues to struggle, with weakness in
energy and trade putting a damper on investment. In
addition, a historically low unemployment rate is making
it challenging for many companies to add the workers
they need to scale up production.
In our view, fixed income investors are more likely to
detect recessions before other market followers. One
warning sign fixed income investors saw in 2019 was a
series of yield curve inversions, locking in lower yields on
long-term Treasury notes while demanding higher yields
from short-term Treasury bills. Historically, inverted yield
curves have predated recessions.
The decade-long bull market could make a strong case for
passive investing in equities. Now, this same sentiment
may convince fixed income investors to do the same.
However, we would argue equating passively managed
equity investing with passive fixed income investing is
like comparing apples to oranges.
The one-size-fits-all attraction of passive fixed income
strategies can expose investors to greater risks than
those associated with equity index funds.
The average option-adjusted spread (OAS) stands at
approximately 75% of the 10-year average for Bloomberg
Barclays U.S. Aggregate Corporate Index, the Fund’s
benchmark, despite the fact that the credit quality of the
index deteriorated dramatically over that time. The
BBB-rated weight within the index has risen by nearly
15% over that time to over half of the investment
The current credit cycle is much closer to its end than its
beginning. Fortunately, credit markets are resilient,
dynamic and often provide opportunity to investors who
prefer to not run with the herd. The key to being prepared
for the next slowdown is to rely on the fundamentals of
credit investing, recognizing that credit rating or
benchmark weight has limited correlation to actual risk
in difficult markets.
The case for a more nimble approach
We believe there are fundamental flaws with major credit
indices because the basic premise upon which these
credit indices are constructed is inadequate. The concept
that a higher debt load results in a larger index weighting
is offensive to even the most novice credit investor.
Unlike the major equity indices, which are largely a
reflection of the market’s valuation of expected company
earnings capacity, fixed income benchmarks reward
aggregate debt. Given the massive increase in debt
issuance over the past 10 years, this should be very
concerning to credit market participants. In fact, the Bloomberg Barclays U.S. Aggregate Bond Index raised the
minimum debt criteria in 2017 from $250 million to $300
million as increased incentive to profligate borrowing.
Source: Bloomberg Barclays, Securian Asset Management, Inc. Illustrates the degradation in credit quality despite tightening credit spreads, 2009-2019. Past performance is no guarantee of future results.
Furthermore, the idea that fixed income indices are “passive”
is largely a fairytale. Certainly, the financial capacity of any
company to service its nominal debt load must be considered
in determining its credit worthiness. Rating agencies make
active decisions that impact which issuers will be included
within a particular index and which ones will be left out. The
credit rating decision is very much arbitrary and very much
active. For example, giving one company years to reduce debt
after a large acquisition while penalizing another
immediately. They may see one industry as more defensive
than another or give credit to companies that have larger
scale while penalizing those that are smaller. Given the
performance of the rating agencies, particularly in times of
turmoil, there should be little comfort in credit ratings.
The critical flaws of the benchmark framework have been
exacerbated by increased dependence upon them since the
last recession. Behemoth asset managers in fixed income
markets have increased the risk to investors. Their sheer size,
a limited market liquidity environment and the comparative
ease of modeling larger benchmark securities has resulted in
a crowding effect in large capital structures. The increased
adoption of passive investment vehicles to gain quick
exposure to fixed income markets has also increased the risk
This increasing credit risk reduces the overall credit quality
of passive funds that track to the Bloomberg Barclays U.S.
Aggregate Bond Index. Why? Because their mandates often
restrict deviations from the index. This means they must
take on the added debt of constituent companies, even if
their underlying fundamentals are weakening.
Among active fixed income managers, smaller fixed income
managers whose funds have a nimble level of assets relative
to behemoth fund complexes can have certain advantages.
They’re not pressured to hold hundreds or thousands of
positions to keep the portfolio fully invested. Smaller fixed
income managers are able to take advantage of offbenchmark
credit opportunities by applying an active,
fundamental approach to reviewing credit and not being tied
to only holding securities that are held in the benchmark.
Flexibility in portfolio construction allows for the ability to
select bonds and structured securities that offer greater
opportunities for yield and avoid companies that are
potentially overly indebted.
Why this matters for long-term investors
It is easier for nimble fixed income managers to efficiently
focus on the smaller end of the fixed income market for the
potential of better risk-adjusted returns. Because they’re not
bound by broad index constraints, the smaller managers can
rely on their own proprietary research tools to manage credit
risk and identify yield opportunities. They can identify yield
premiums by using technical analysis to identify dislocation
and mispricing opportunities within sectors or among
individual securities. In addition, their mandates often
allow them to take advantage of yield premiums offered by
private placements and other alternative investments. And
when recessions occur, their smaller portfolios often enable
them to exit positions more efficiently and thoughtfully than
larger firms that must quickly make hundreds of trading
decisions to generate liquidity to accommodate outflows.
An example is in the structured market with Credit Risk
Transfer (CRT) Bonds. CRTs were created in 2013 to
transfer portions of risk from conventional residential
mortgage loans backed by government-sponsored agencies, such as Fannie Mae and Federal Home Loan Mortgage
Corporation (Freddie Mac), to private sector investors. These
are unsecured general debt obligations, with principal and
interest payments made on them monthly by the issuing
government-sponsored agency. They have a floating rate of
payment indexed to the 1-month LIBOR rate and a maturity
of either 10 or 12.5 years.
In general, we use fundamental bottom-up research and seek
to add value to the portfolio through security selection.
We have been an investor in residential credit for many
years. In selecting CRT bonds, we employ scenario analysis
to stress the bonds under a range of economic environments
by shifting several variables (i.e. prepayment speeds, defaults
rates, and recoveries). In addition, these bonds provide the
portfolio with consumer credit exposure, which is an
important source of diversification away from corporate
credit. We find the CRTs to be a fit within our portfolio
because, on average, they tend to offer borrowers with
excellent credit scores, geographically diverse home
ownership locations and floating rate coupons, which
benefit during periods of rising interest rates.
An uncertain fixed income market favors managers who can
be nimble and selective and focus on finding yield premiums
and higher credit quality outside the larger issuer universe.
For example, right now, bonds from highly rated (A to A-)
smaller issuers offer a yield premium ranging from 9 to 41
basis points higher than their larger counterparts. Some of
this yield premium reflects the overall lack of market
efficiency in the small end of the market. With mainstream
investors favoring larger issuers, bonds from smaller
companies are often undervalued, providing open-minded
fixed income investors with opportunities to selectively
exploit these opportunities.
When the economy is on a roll and markets are rising,
investing in passive funds and active index-huggers may
seem like the thing to do. However, when warning signs like
weakening fundamentals and declining credit quality rear
their ugly heads, prudent fixed income investors may be
better off shifting some of their assets to smaller, more
nimble fixed income asset managers who may be better
prepared to weather the approaching storm.
Index Credit Rating
# of Issuers
Option-Adjusted Spread (basis points)
Less than $5B
$5 - $20B
Greater than $20B
A+ to A-
Source: Bloomberg Barclays U.S. Aggregate Corporate Bond Index and Securian Asset Management, Inc.
Chart looks at the aggregate amount of debt outstanding by issuer and the OAS on each index-eligible issue. Past performance is no guarentee of future results.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through
February 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not
intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial
needs, risk tolerance and time horizon.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit
Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Investing in below investment
grade securities may carry a greater risk of nonpyment of interest or principal than higher-rated bonds. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be
offered at all broker/dealers.
The Bloomberg Barclays U.S. Aggregate Bond Index is market capitalization weighted index, representing most U.S. traded investment grade bonds. It is not possible to invest directly in an index.