By Fran Kinniry
- The historical underperformance of actively managed bond funds during rising-rate periods reinforces the challenges of accurately predicting the path of interest rates.
- Recent history is no different. From May 1 to August 30 of this year, a period of rising rates, 70% of active bond managers underperformed their benchmarks.
- The recent sell-off of fixed income securities offers clients an opportunity to gain exposure to high-quality, low-cost, broadly diversified bond index funds.
During rising-rate environments, investors frequently assume that actively managed bond funds will outperform their benchmarks. Given that active managers have the tools and expertise in their arsenal to maneuver portfolios in anticipation of a rise in interest rates, shouldn't they have an advantage?
Vanguard has found evidence to the contrary. "In prior research, we looked at seven rising-rate periods since 1981, and the majority of active bond funds, on average, historically failed to outperform their benchmarks," said Fran Kinniry, a principal in Vanguard Investment Strategy Group. (Christopher B. Philips and David J. Walker, 2011. Rising rates: A case for active bond investing? Valley Forge, Pa.: The Vanguard Group.)
The findings are also similar for more recent periods.
The table above shows the percentage of active bond managers that underperformed their benchmarks during three recent periods of rising interest rates. We found that:
- During the interest rate surge that started in May of this year, 70% of active bond managers underperformed their benchmarks through August 30, earning a median excess return of –0.72% over 4 months. (Note that August 30 is the end date for our calculations, and not necessarily an end to the recent rising-rate environment.)
- During the rising-rate environment that started on June 1, 2012, which includes the recent surge as a subset, 81% of active bond managers failed to outperform their benchmarks. (The analysis was extended to include the 10-year U.S. Treasury yield's inter-period low of 1.47% on June 1, 2012.) The median excess return of active bond managers during this 15-month period was –1.80%.
- During the rising-rate period from October 7, 2010, through February 8, 2011, 39% of active bond managers underperformed. While the data for this period point to a majority of active managers outperforming, the median excess return was small at 0.30%.
More interesting is that a majority of active bond managers underperformed after the rising-rate period that ended February 8, 2011, as calculated by Vanguard Investment Strategy Group:
- In the subsequent 3-month period, 63% of active managers underperformed, with a median excess return of –0.22%.
- In the subsequent 6-month period, 72% of active managers underperformed, with a median excess return of –0.78%.
- Over the following 12-month period, 62% of active managers underperformed, with a median excess return of –0.52%.
The Challenge of Predicting Rate Direction
Even if the general direction of interest rates is higher, as many believe, correctly getting the timing, the magnitude, and the duration of interest rate changes is crucial. The recent surge in rates that began in May caught many investors off guard. And the resulting broad underperformance of actively managed bond funds, among even some of the most venerated active bond managers, reinforces the challenges of accurately predicting the path of interest rates. History has shown that interest rates will likely evolve differently from today's expectations.
The market has been clamoring about rising rates since 2010, but on August 30 of this year, the 10-year Treasury rate was only 20 basis points higher than it was two years ago (on August 30, 2010, the rate was 2.54%). Over that time period, some managers who anticipated upward pressure on interest rates may have found themselves on the wrong side of a trade anticipating interest rate moves.
"The implication of recent performance is that investors should not automatically assume that an active manager will transform an opportunity into actual outperformance. The recent sell-off in fixed income has created a good opportunity to rebalance and diversify into high-quality, low-cost, broadly diversified bond index funds," Kinniry said.
(High-quality bonds include U.S. Treasuries and other fixed income securities with a credit rating of Baa3 or higher by Moody's or a credit rating of BBB- or higher by Standard & Poor's or Fitch.)
Disclaimer: All investing is subject to risk, including possible loss of principal. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.