Investment Strategies

Active Matters: Tapping into Bond Market Inefficiencies

Bond market complexities call for an active approach. In an interview with Barron’s, portfolio manager David Braun explains why passive bond ETFs may fall short and how exploiting structural inefficiencies may give active managers an edge over their passive peers.

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David Braun, Managing Director, PIMCO: So, we’re often asked about the flaws of index construction in the bond world, and when you think about when you build a bond index, you’re by definition putting more bonds of the most indebted companies or issuers in there. So when you look at the Barclays Agg, the bellwether index that the majority of funds are benchmarked to, first you'll notice the treasury component of the index has increased significantly over the last ten years,

Shots of the U.S. Federal Reserve building and money being printed.

because the US Treasury has been running deficits and issuing more treasuries.

So if you’re indexing to the Agg, you’re by definition lending more to the most indebted issuer, in this case, the treasury. Second, on the corporate side, one of the large components of the index, you’re by definition lending more to the companies that have more weight in the index.

Archival footage of people in a bank.

And I’d like to think about an analogy here. If you ran a bank, and you were the senior loan officer at a bank, and someone walked into your door and asked for a loan, and your first and primary question to them was, “how much existing debt do you have outstanding?”

And if they had a lot of debt outstanding, you’d give them a big loan. If they had a little debt, you’d give them a little loan, if they had no debt, you would give them no loan. That’s what you’re in essence doing when you’re replicating a bond index.

Shot of person using stylus to navigate a computer screen.

You’re lending to the most indebted companies, and not lending to the lowly-indebted companies. We try to do almost the opposite of that. We’re trying to find the companies that there’s a strategic reason why they’re adding some leverage to their balance sheet and debt to their balance sheet, and we’re getting fairly paid for that.

Shot of skyscrapers.

Oftentimes, the companies that are in the index have a structural advantage in that their bonds are in higher demand by index replicators

Shot of person using a laptop to look at trading information.

and low active share, active managers who are kind of hugging the benchmark. That gives them a financing advantage where their spreads are lower. Their bonds are more well-known, their bonds are more well-covered, certain people have to buy them in order to reduce their tracking error, and their spreads are tighter. That leaves, hopefully, potentially wider spreads on the bonds that aren’t as covered, or an active bond manager can cultivate those spreads.

Series of screenshots of articles discussing active vs. passive investing.

There’s been a big movement and big debate in the ETF world and the bond side about active versus passive. We actually think a lot of the flow that’s going into passive has almost been inadvertent — where, as ETFs begin to rise in prominence, a lot of people, knee-jerk reaction, concluded it must be like equities, were passive is the way to go.

Shots of person using tablet to look at stock information.

If you look at the empirical data, PIMCO agrees, it’s been really hard for active equity managers to beat their median passive peer group.

On the other side, when you look at bonds, the data is different. Over two thirds of active managers have successfully beaten their passive median peer group.

Photo of screen with stock information on it then a photo of the New York Stock Exchange Building.

And a couple reasons why bonds are different in that case. The market’s just different, right? The equity market is incredibly transparent,

Shot of a person on the phone in front of a set of computer monitors.

much, much fewer issuers, the bond market is largely over the counter, the tens of thousands of issuers, and at the end of the day, that creates structural inefficiencies in the bond market, that a passive manager can’t cultivate, but an active manager can.

Second, if you look at the bond market, it’s over 100 trillion dollars globally, and roughly 50 percent of those bonds end up in the hands of non-economic investors.

Photographs of the President of the European Central Bank, Mario Draghi and Chairman of the U.S. Federal Reserve, Jerome Powell

And what I’m talking about there are central banks, who need to buy bonds to manage foreign currency reserves, or buying bonds as part of their quantitative easing programs,

Photograph of stone sign that reads CalPERS (California Public Employees’ Retirement System)

or asset liability management driven investors, who are buying a bond simply to defuse the liability, rather than buying and selling bonds in order to generate alpha.

So, the fact that 50 percent is being held in those hands creates an opportunity for us and the other 50 percent to extract alpha out of the market that’s left out there.

Disclosure


Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including the risk that fixed income securities will decline in value because of changes in interest rates; the risk that fund shares could trade at prices other than the net asset value; and the risk that the manager's investment decisions might not produce the desired results. Management risk is the risk that the investment techniques and risk analyses applied by an active manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Investors should consult their investment professional prior to making an investment decision.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. It is not possible to invest directly in an unmanaged index.

References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The Italy branch is additionally regulated by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Deutschland GmbH Italian Branch (Company No. 10005170963), PIMCO Deutschland GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Spanish Branch and Swedish Branch are additionally supervised by the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act, the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and  203  to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008 and the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act, respectively. The services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia). This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (107) FSC SICE Reg. No.001. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.), Tel: +886 (02) 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. This material is published by Barron’s. Date of original publication 20 May 2019.

CMR2019-0723-407180

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