[This article appears in our November 2019 issue of ETFR.]
I’ll be honest: Bond investing is weird.
Every so often, my wife, who teaches teenagers for a living, asks me to come in and talk to her students about investing. Like any well-trained (however ancient) MBA student, I diligently talk about the kinds of things one can do with investable money.
Once upon a time, I started with simply depositing money in the bank, but it’s become evident to me over the past decade that this young generation actually understands equity at a genetic level. So I start there. Every one of those kids—whether they’re from well-to-do or struggling backgrounds—gets the concept of ownership.
They get, through cultural indoctrination, that you can buy a slice of Apple, and if Apple does really well, you make money. They get it at the entrepreneurial level, so much so that they talk about raising money from friends to start (I’m not making this up) companies that grow gourmet mushrooms in their basements.
Raw Deal For Savers
But then I try to explain the basic concept of a savings account, and their minds explode.
“Wait,” goes a typical response. “I give the bank $100, and in a year, I earn $1. But the bank takes my money and loans it to someone else to buy a house, and it earns $4? That’s a raw deal!”
Naturally, I go on to explain that they too could own mortgages if they wanted to, and I talk about corporate debt, and the whole conversation quickly devolves into “why should I loan money to potential deadbeats?”
And then, if I’m lucky, the bell rings and I can go home to do my actual job, which is frankly a whole lot easier than talking to teenagers.
Bond Investing Gets Weird
But the point sticks with me: Bonds are weird, and bond investing is even weirder. Consider how most bond indexes are structured: The institution that asks for the most money is the one with the biggest weight in the index. In teenager-speak, we loan the most money to the firms most likely to end up as deadbeats.
And of course, the pattern of returns in bonds is wildly asymmetrical: As investors, we either receive our money back, with coupon payments, or we get literally nothing, when the deadbeats default. With a stock, under- and overperformance shows up directly, almost linearly, in our returns.
This is such a big issue that, unlike with stocks, the buy-side community for bonds is utterly dependent on third-party rating agencies to at least shore up the baseline of their investment processes—active or passive. When was the last time you read about a stock being kicked out of an index because “its rating slipped?”
Active Vs. Passive
All of this asymmetric uncertainty is why the market consistently believes there’s a strong case for active managers in fixed income. After all, blindly following issuance or duration or rating statistics seems, intuitively, to be a dumb idea. And yet, year after year, the story in bond funds is generally the same as it is for equity funds: It’s the rare active manager that actually adds risk-adjusted alpha.
In the past 20 years, I can’t think of a really significant innovation in fixed income investing. Sure, there are some papers on my nightstand, but they’re playing with the edges of efficiency and execution, not radically reimagining how we think about debt. It’s as if we have a collective myopia where we all agree that “bonds are boring and stocks are exciting” and leave it at that.
I desperately want to be proven wrong. Somewhere out there, there’s a wet-behind-the-ears CFA who’s going to shake up our whole thinking about bonds. If you know them, please, please, encourage them. And then invite me for coffee.