The global financial crisis prompted many investors to shift a significant amount of fixed-income assets out of actively managed strategies to exchange-traded funds or passively managed index funds.
However, Janus published a report recently to highlight the relevance of an active management strategy in an environment where there is upward pressure on interest rates (Choosing the right strategy: Why active fixed income makes sense in today’s environment).
One of the fallouts of the crisis and subsequent government intervention in the credit and mortgage markets has been the convergence of government agency and agency mortgage spreads, Janus notes. Government agency debt and agency mortgages have had similar yields to US Treasuries since late 2008, when the US government placed Fannie Mae and Freddie Mac into a conservatorship.
Janus suggests that this event resulted in a structural change within fixed income, reducing the number of sectors from four to two: corporate credit and government (see exhibit 1). It believes this structural change will persist, and notes its implications on one of the indices most commonly used by passive investors: the Barclays Capital US Aggregate Bond Index (AGG).
The low interest-rate environment and the AGG’s longer duration make the index more sensitive to interest-rate movements, says Janus. As a result of loose underwriting standards and relatively low interest rates between the late 1990s and 2006, agency mortgages gradually increased to make up a larger portion of the AGG, much of it at the expense of US Treasuries. Janus anticipates a rise in rates will reduce the pace of refinancing for existing mortgages, leading to duration extension and an increase in sensitivity of mortgages to rising rates.
But Janus notes that the risk/return characteristics of agency mortgages have changed since the crisis, driven by the narrowing of agency and agency mortgage spreads relative to US Treasuries – largely the result of US government intervention. This included the Federal Reserve’s $1.25 trillion mortgage purchase programme that ended in March 2010. Agency and agency mortgage spreads are below long-term averages, and Janus believes this trend will likely reverse, potentially leading mortgages to underperform credit.
While the Fed is no longer purchasing agency mortgages, it still held more than $1 trillion on its balance sheet at the end of May. Janus points out that the Fed will need to liquidate most of these holdings at some point, which could have significant implications for yields, spreads and overall relative performance of agency mortgages and the AGG.
Owning the AGG exposes investors to the risk of widening mortgage spreads, says Janus, while noting that passive investment strategies have underperformed most active strategies for the last four quarters.
Janus believes this could persist, given the AGG’s composition and the likelihood of rising interest rates. “Active management, particularly security selection within the corporate credit sector, may be the single most important factor in generating risk-adjusted outperformance in fixed income,” the firm concludes.