Legg Mason Thought Leadership THE CASE FOR ACTIVE IN FIXED INCOME NOW Finding attractive opportunities in today s fixed-income markets is not an easy task, with already-low yields and persistent uncertainty about the future direction of central bank policies. The challenge is particularly acute for investors who choose to forgo the flexibility and versatility available via active management important resources given the hard realities of today s interest rate environment. Yet many investors rely heavily on passive investments to populate their fixed-income allocations. Some see index-based strategies as less vulnerable to market extremes; others believe that potential savings on fees outweigh the potential for gains. This document reflects the opinions, views and analysis of Western Asset regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal. OCT 2017 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
The active advantage It s not difficult to see how the constraints of a passive index approach may limit opportunities and potentially increase interest rate risk, but do active solutions really deliver better results than passive ones? Clearly, active strategies do not have to outperform passive ones 100% of the time in order to merit a portfolio allocation. All that matters to the end investor is how well the specific active strategies that he or she holds may perform not the category as a whole. In fixed income, some strategies clearly do deliver a performance advantage. Consider the following analysis of the institutional share class of Morningstar s U.S. Open End Intermediate-Term Bond Fund Universe. As of the end of September 2017, the median total return of actively managed funds in that category was better than the Bloomberg Barclays Aggregate Bond Index 1 across 1, 3, 5 and 10 year periods. In other words, half of the actively managed funds in this universe outperformed the aggregate benchmark in the periods shown. The outperformance of funds in the top two quintiles is even more impressive. Active fixed income managers can outperform Active Intermediate-Term Funds versus Bloomberg Barclays Aggregate Total return (%) Median Active Total Return Top Quintile Active Total Return Second Quintile Active Total Return Bloomberg Barclays Aggregate Bond Index 1-year 3-year 5-year 10-year 0.97 2.83 2.44 4.65 2.08 3.29 3.05 5.20 1.27 2.98 2.58 4.76 0.07 2.71 2.06 4.27 Source: Morningstar and Bloomberg, as of September 30, 2017. Active total returns are represented by Morningstar US Open End Intermediate-Term Bond Funds (Institutional Class Only), which includes no ETFs, no Fund of Funds & no Money Markets. The returns are net of fees/expenses. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. Of course a top-performing fund may not be a top-performing fund next year; performance can and does fluctuate, especially over shorter periods of time. And some actively managed funds may never outperform the benchmark. However, many do and some are consistently among the top performers providing an important choice for investors who seek to do better than average whether based on ambitious goals or the willingness to take rational chances in pursuit of exceptional returns. 1 The Bloomberg Barclays U.S. Aggregate Index is a broad-based bond index comprised of government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity.
The road not taken In many ways, the criticism most often leveled at active management amounts to this: that because it doesn t always beat an index after fees, it is somehow less legitimate or desirable than something that reliably tracks that index. Yet that s judging active by a standard it was never meant to meet. Active management cannot guarantee any particular result, but few things in life are guaranteed. The idea that all investors must be condemned to average results is a huge value judgment that fails to respect the choices that individuals may desire. Does the implicitly higher volatility of active strategies make them less suitable for everyone? Of course not the important thing is that investors understand what the potential for additional gain or loss may be for a given active strategy. So what is the opportunity cost that an investor confronts when selecting a passive strategy? Opportunity cost, of course, refers to a benefit that someone could have received, but gave up by taking a different course of action. Such tradeoffs apply to passive strategies, which like all investments, have implicit tradeoffs. What are the key tradeoffs to recognize now? Passive index investing can limit exposure to sources of potential return. Fixed-income investment opportunities in credit markets and especially outside of the U.S. have grown dramatically over the last few decades. There is far more debt being issued and by more issuers than ever before. Yet the most widely used passive bond strategies do not invest in this larger opportunity. A quick look at the composition of the traditional benchmark for these strategies reveals why. Consider the Bloomberg Barclays U.S. Aggregate Bond Index the dominant benchmark for the category. It focuses on large, liquid, fixed-rate investment-grade securities, and is issuance-weighted; the more than an entity borrows, the bigger its representation in the index. At the end of September 2017, three types of securities accounted for roughly 93% of the index: Treasuries (37%), pass-through mortgage-backed securities (30.5%) and investment-grade corporate bonds (25.5%). This has two important consequences: First, the index excludes nearly two-thirds of the investable fixed-income universe including below investment-grade securities 2, non-u.s. developed and emerging market 3 bonds, non-agency mortgage-backed securities, private bank loans and securities with adjustable rate features where yields tend to be higher. Second, there s little diversification within the index: its major components are historically tightly correlated 4 to one another. 2 High yield, or below-investment grade bonds are those with a credit quality rating of BB or below. 3 Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries. 4 Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
Passive index investing can increase duration 5 or interest rate risk. As rates have moved lower since the 2008 financial crisis and as corporate and government issuers have moved out the yield curve 6 to take advantage of attractive long-term funding the duration of the Bloomberg Barclays Aggregate Bond Index has drifted higher, from 4.41 years at the end of 2007 to 5.96 years at the end of September 2017. 7 For passive strategies linked to the this Index, that means investors are receiving less income to offset any future impact of rising interest rates (interest rate risk) on bond prices. In addition, unlike actively managed solutions, there is no way to opportunistically adjust duration, which can be used to manage the risk of a changing interest rate environment. Bonds with lower coupons are more sensitive to changes in interest rates, and therefore have longer durations than do bonds with higher coupons. Because more of the present value for lower coupon bonds 8 comes from the principal or bullet payment which occurs further out in time, their prices are more reactive to interest rate movements. Most fixed income opportunities are outside the Index (USD billions) 25,000 Bloomberg Barclays U.S. Aggregate Other U.S. Non-U.S. 20,000 18,956 15,000 10,000 8,057 6,122 6,088 6,897 5,000 0 1,114 2,367 2,150 1,934 69 1,328 1,620 593 271 U.S. Government U.S. Investment- Grade Credit U.S. Securitized U.S. STIPS Other Investment- Grade Corporate Hybrid and Floating Rate Securitized High-Yield Corporate Bonds and Bank Loans USD Emerging Markets Global Government Global IG Corporate Global Securitized Global Inflation-Linked Global HY Corporate Euro Emerging Market Source: Bloomberg Barclays, as of September 30, 2017. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 5 Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years. 6 The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities. 7 Source: Bloomberg Barclays, as of September 29, 2017. 8 Coupon is the periodic interest payment made to the bondholders during the life of the bond.
Active bond strategies can access more attractive sectors Recognizing the opportunity In contrast, an actively managed portfolio freed from the rigid constraints of an index can access a broader opportunity set in which to seek higher income and total return. Using in-depth analysis of specific securities, sectors, and/or macro influences, active managers can leverage their flexibility to identify attractive prospects within this expanded set. In addition, sector rotation may allow them to opportunistically reweight allocations as conditions change, with the goal of enhancing risk-adjusted returns 9 and mitigating interest rate risk. Active bond managers can enhance exposure to sources of potential return. Income is always an important contributor to total return. But based on yield, the most attractive current income opportunities are not found in the sectors heavily represented in the aggregate benchmark, but instead in such areas as below investment-grade securities, non-u.s. developed and emerging market bonds, private bank loans and securities with adjustable rate features. Yields & correlations of select fixed income sectors to U.S. Treasuries (%) 8 6 4 Bank Loans High Yield EM Corporate EM Sovereign CMBS 2 U.S. IG Corporate MBS ABS U.S. Treasury Government-Related 0-0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2 5-year correlation to U.S. Treasuries Source: Bloomberg as of September 30, 2017. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflectb any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. EM Corporate is represented by the Bloomberg Barclays EM USD Corporate and Quasi-Sovereign Index, which is the corporate and quasi-sovereign component of the Bloomberg Barclays EM USD Aggregate Index, which is a hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bank loans are represented by the S&P/LSTA U.S. Leveraged Loan 100 Index, which is designed to reflect the performance of the largest facilities in the leveraged loan market. High Yield is represented by the Bloomberg Barclays U.S. Corporate High Yield Index, which covers the universe of fixed rate, non-investment grade debt, including corporate and non-corporate sectors. EM Sovereign is represented by the JPMorgan Emerging Markets Bond Index Plus (EMBI+), which is a total return index that tracks the traded market for U.S. dollar-denominated Brady and other similar sovereign restructured bonds traded in the emerging markets. U.S. IG Corporate is represented by the Bloomberg Barclays U.S. Investment-Grade Corporate Index, which is the corporate component of the U.S. Credit index, which is part of the Barclays Capital U.S. Aggregate Bond Index. CMBS is represented by the Bloomberg Barclays Commercial Mortgage-Backed Securities (CMBS) Index, which is the CMBS component of the Bloomberg Barclays U.S. Aggregate index. MBS is represented by the Bloomberg Barclays U.S. Agency Mortgage Backed Securities (MBS) Index, which is the U.S. MBS component of the U.S. Aggregate index. The MBS Index covers the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Please note an investor cannot invest directly in an index. ABS is represented by the Bloomberg Barclays Asset-Backed Securities (ABS) Index, which is the ABS component of the Bloomberg Barclays U.S. Aggregate index. Government-Related is represented by the Bloomberg Barclays Government-Related Index, which is the Government-Related component of the U.S. Aggregate index. US Treasury is represented by the Bloomberg Barclays U.S. Treasury Index, which is the U.S. Treasury component of the U.S. Government index. 9 A risk-adjusted return is a measure of performance relative to its level of risk exposure over a given period of time.
While that is generally true in most fixed-income environments, current spreads 10 in some credit sectors may be particularly favorable for fundamental analysts to uncover mispriced securities with the potential to appreciate in price. After all, at current yield levels, U.S. Treasuries and other government-issued securities have limited room to appreciate unless interest rates fall further at present, an unlikely scenario. Conclusion The ability to access opportunistic sectors of the broad bond market is critical today, whether it s for income, total return potential, portfolio stability or all of the above. The right active approach could potentially provide investors with a distinct advantage over a passive approach. Therefore the most relevant question for investors and their advisors isn t, Do actively managed solutions outperform passive ones? but rather, Have I chosen an actively managed solution with a solid track record of outperformance? and Can the potential outperformance help meet long term goals? Investment risks High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues. Asset-backed, mortgage-backed or mortgage related securities are subject to additional risks such as prepayment and extension risks. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Active management does not ensure gains or protect against market declines. Outperformance does not imply positive results. Diversification does not assure a profit or protect against market loss. Yields represent past performance and there is no guarantee they will continue to be paid. 10 A spread is the difference in yield between two different types of fixed income securities with similar maturities.
Brandywine Global Clarion Partners ClearBridge Investments EnTrustPermal Martin Currie QS Investors RARE Infrastructure Royce & Associates Western Asset Legg Mason is a leading global investment company committed to helping clients reach their financial goals through long term, actively managed investment strategies. $741 billion* in assets invested worldwide in a broad mix of equities, fixed income, alternatives and cash strategies A diverse family of specialized investment managers, each with its own independent approach to research and analysis Over a century of experience in identifying opportunities and delivering astute investment solutions to clients IMPORTANT INFORMATION: All investments involve risk, including possible loss of principal. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors. The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any). This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the $ (dollar sign) represents U.S. Dollars. LeggMason.com * As of June 30, 2017. 2017 Legg Mason Investor Services, LLC. Member FINRA, SIPC. Legg Mason Investor Services, LLC and all entities mentioned above are subsidiaries of Legg Mason, Inc. 762219 MIPX316242 10/17