The Challenge
Bonds are having a moment. After years of near-zero rates, the “great rate reset” of 2022 pushed yields higher, making bonds attractive again as a source of income. This is particularly good news for a $58.2 trillion US bond market1 that can play a vital role in portfolios, offering income, diversification and capital preservation.
Yet indexing, while often an efficient and effective approach for stocks, faces different challenges when applied to the more complex bond market. For example, an equity fund benchmarked to the Russell 3000 aims to offer access to 98% of US stocks2. A bond fund tied to the Bloomberg Aggregate Bond Index, however, covers only 47% of the US bond market3.
That’s partly because bond indexes are weighted by outstanding debt. “In the equity world, the components that become bigger tend to be the companies that are doing well,” says Celso Munoz, Portfolio Manager (FTBFX, FBND), Fixed Income at Fidelity, who began his career as a research analyst and has been with the company for 20 years. However, in fixed income, “the components that tend to get larger are the companies or the entities that are most indebted, which is often a negative thing.”
While only 47% of bonds are tracked by the Bloomberg benchmark, there’s roughly another $30 trillion in bonds outside the benchmark that passive investors can’t access. And it’s in that opaque part of the market where opportunity lies.
“As active managers, we’re fishing in a much bigger pond,” Munoz says.
The Impact
The complexity of fixed income is hard to overstate. Bloomberg’s Aggregate covers 13,000 bonds4—a fraction of the millions outstanding, each with its own maturity, coupon and call schedule.
Take municipal bonds: There are over 1.5 million CUSIPs and over 50,000 issuers, explains Cormac Cullen, Portfolio Manager (FLTMX, FMUB), Fixed Income at Fidelity, who has been in the industry since 2001 and previously served as a research analyst. Yet on any given day, only about 1% of those CUSIPs trade. That illiquidity and fragmentation create pricing disconnects—and opportunities for those with the resources to dig deeper.
“For equity analysts, there is one stock behind every ticker,” says Cullen. “But in the world of fixed income, every ticker can represent all sorts of different bonds. Given that complexity, you often find mispriced bonds, or mispriced relationships between those different types of bonds.” That might mean capitalizing on a misaligned yield between senior and subordinated debt or taking advantage of structural differences between short- and long-dated bonds.
For retail investors, the scale of analysis required makes this nearly impossible. “It’s the type of surveillance that would be really hard for your average investor to do on their own,” Cullen says. But Fidelity’s bench of credit analysts, macro strategists, traders, and experts across asset classes—drawing on their multiple perspectives and diversity of thinking—makes it possible to exploit these inefficiencies. Active managers can identify when a company’s fundamentals suggest an upgrade or downgrade, well before ratings agencies or indexes catch up.
The Takeaway
Today’s bond market doesn’t just look appealing – it could offer the opportunity for positive outcomes. That’s because income levels are now high enough to cushion most declines.
Munoz offers an example of this bond math in action: When yields are 4%, that means an investor earns 4% in income over 12 months. If yields rise by 1%, bond prices might fall 6%. Subtract the 4% income, and you’re left with a 2% loss – a manageable downside risk. But if yields fall by 1%, prices could climb 6%. Add 4% income, and you’re up 10%.
“That’s a really good risk-reward,” says Munoz. “The fact that such a big portion of your return is driven by income right now makes the bond market really attractive.”
Capturing this opportunity requires more than just showing up. In a fragmented, inefficient market with millions of securities, timely execution matters as much as opportunity.
This is where active management is designed to deliver an edge. Passive investing waits until upgrades are official – often after the price move has already happened. Active managers, by contrast, can act on early signals, purchase bonds with strong fundamentals and avoid issuers weighed down by excessive debt.
“We’re actually looking for the stone that hasn’t been overturned, picked up, and looked at,” says Cullen.
In an opaque, negotiated market that trades over the counter, Fidelity’s team-based approach – grounded in research and trading expertise, as well as global scale – gives their managers the opportunity to exploit inefficiencies others can’t. With in-depth analysis and the flexibility to go beyond the benchmark, they can target securities that look like the index, but with greater return potential.
It’s here – in the 53% of the fixed income market not covered by the benchmarks – where true alpha may be found.
Created by Fidelity and Bloomberg Media Studios.