January 2024 / INVESTMENT INSIGHTS
The active advantage in high yield
Active approach allows security selection and strategic positioning
Key Insights
- Active management of high yield bonds offers several advantages over a passive approach, in our view.
- Relative to equities, there are inherent complexities in bond markets that make it difficult and expensive to replicate the composition of an index.
- Active management allows for fundamental analysis across the full high yield universe as well as the ability to strategically reposition a portfolio.
There is a strong case to be made for active management in high yield bonds, in our view, with an active approach offering several important advantages. Active management allows for fundamental analysis and security selection across the full high yield universe as well as the ability to strategically reposition a portfolio to take advantage of macro trends or to capitalize on relative value opportunities.
We take an active, flexible, concentrated approach to the high yield market and seek to generate alpha1 through a high-conviction portfolio of best ideas. Our active approach is supported by proprietary fundamental credit research performed by a seasoned and collaborative team of investment professionals who focus exclusively on the high yield market. We believe our active approach to high yield can help improve investor outcomes and mitigate downside risks over the long term.
High yield indexes are difficult to replicate
There are drawbacks associated with passive high yield investing. Particularly relative to equities, there are inherent complexities in bond markets that make it difficult and expensive to replicate the composition of an index or its returns:
Large, complex investment universe: Unlike stocks, which each have a single ticker symbol, bond issuers typically have multiple issues in the market. While the S&P 500 Index has roughly 500 constituents, the ICE BofA U.S. High Yield Constrained Index consists of 1,872 issues from about 886 issuers.2 As a result, investment decisions not only boil down to which companies to own but also which specific issues.
Trading costs and complexities: High yield fixed income trading continues to be largely conducted over the counter rather than on an exchange like equities. As a result, trading costs are relatively high, making it expensive to build and manage a passive portfolio containing hundreds of issues. This is particularly challenging for passive exchange‑traded funds (ETFs) as many investors tend to use such vehicles for short-term tactical positioning, which involves trading into and out of the market frequently and likely at higher cost.
High turnover: Bond benchmark indexes have experienced significantly higher turnover than most equity indexes. New issuance, bond maturities, corporate actions such as tender offers, and credit rating upgrades and downgrades are all contributing factors that have caused the composition of the ICE BofA U.S. High Yield Constrained Index to continually change, resulting in higher index turnover relative to equities.
Minimum size requirements: Most large passive ETFs impose minimum size requirements, such as a minimum USD 1 billion outstanding face amount at the issuer level or a USD 400 million outstanding face value at the issue level. These restrictions can greatly reduce the investable universe and can result in passive ETF holdings being concentrated on the largest, most liquid bonds within the index.
As a result, tracking error for passively managed high yield strategies tends to be high relative to equities, and it has been difficult for passive strategies to outperform over longer time periods.
How active managers can add value
The high yield market provides a variety of compelling opportunities for active managers to add value. Here we highlight just some of the ways we seek to add value through active management:
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January 2024 / ASSET ALLOCATION VIEWPOINT
Kevin Loome is a portfolio manager in the Fixed Income Division. He has lead portfolio management responsibilities for the US High Yield Bond Strategy.
Ashley Wiersma is a portfolio specialist for the US High Yield Strategy at T. Rowe Price Investment Management. She is a vice president of T. Rowe Price Group, Inc.
