Fixed income
Navigating uncertainty: The case for active management in fixed income
6 min read 29 Jan 26
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Benjamin Franklin said “the only thing certain in life is death and taxes”. We might add ‘market uncertainty’ to that. From the pandemic to the trade war, investors are constantly having to adapt. When volatility and uncertainty are the watchwords of the day, active management in fixed income investing could be more important than ever.
With credit spreads at historically tight levels, there are concerns that yield-buyers in credit markets are being complacent about the myriad of risks – economic, political and fiscal – facing investors. In this environment of uncertainty, an active approach may enable investors to move up in quality while also uncovering pockets of value, as well as to mitigate risks and avoid pitfalls when spreads widen.
Pulling the duration lever
Since the post-Covid inflationary bout, the uncertain trajectory of both interest rates and the economy has plagued investors. From central banks initial reluctance to hike interest rates, maintaining that inflation would be ‘transitory’, to then the slow and hesitant descent from the peak, bond investors have been kept on their toes.
One lever at the disposal of an active manager is duration management, in order to help mitigate, and take advantage of, interest rate risk. For example, active bond managers can analyse their macroeconomic outlook and may choose to reduce or increase interest rate risk as one tool to drive potential returns. Meanwhile, passive bond strategies cannot adjust exposure in this way, instead having to match the interest rate risk of a specific bond index. Passive bond strategies typically move lower in duration when yields are high and higher in duration when yields are low – counter to what a bond investor may want (bond yields and prices move in opposite directions).
We believe that there is an asymmetric risk/return profile in duration at the moment. The general direction of rates is more likely to be downwards given the underwhelming level of growth in Europe and the UK and signs of weakness that we are seeing in the labour market. Given that the fiscal policy lever – which has been the weapon of choice when growth issues have been encountered over the last 25 years – is now exhausted, central banks may need to turn to monetary policy in order to stimulate the economy.
"This could be supportive for duration, and for fixed income investors."
Government bond curves globally have steepened dramatically over 2025, partly driven by fiscal sustainability concerns. This has revitalised a lever that has long been forgotten about by many active bond managers – curve trades. We feel that the combination of these factors means that we are in the midst of an opportunity for active management in global bond markets, which could offer performance-driving returns in portfolios.
Pricing risk
2025 has been a year of historically tight spreads which are not necessarily reflective of the macroeconomic picture. This indicates a market that could be struggling to price risk.
From a potential AI bubble to a geopolitical upheaval, the list of risks facing markets is lengthy. Moreover, should a significant risk-off event occur, it is most likely to arise from something completely unexpected. It is important to be nimble and ready to react when valuations reach attractive levels again, because the market tends to sell off suddenly and rapidly – something an active manager may be better placed to do than a passive tracker which is tied to the index level of risk. An active manager is able to move up in quality while spreads are tight, offering protection should spreads widen significantly, and subsequently buy into risk at wider spreads – potentially generating alpha both as spreads widen and as they tighten again.
The danger for a tracker is exacerbated in such a precariously balanced market as bond indices give exposure to the most indebted governments or corporates – the ‘sinners, not winners’. The largest constituents of a typical corporate bond index will usually be those with the largest outstanding amounts of debt – far from the type of issuer to which investors may choose to have a sizeable exposure when spreads do not reflect the risk in the market. This is in stark contrast to an equity index tracker which is typically weighted towards a market’s biggest and, usually, most profitable corporations, which has generally led to the success of passive equity vehicles. This contrast between the construction of equity and fixed income indices highlights the importance of an active approach in fixed income – important for those seeking long-term outperformance.
However, while spreads remain tight, active managers can still seek to generate returns.
"Fixed income markets are inefficient, and this creates opportunities to be taken advantage of."
We believe that fundamental credit analysis is key to identify these opportunities, potentially leading to relative outperformance. It is only through this process that investors are able to gain a thorough understanding of a company’s financial situation and business model and whether there are inefficiencies to exploit. With one of the largest teams of credit analysts in Europe, we believe M&G is particularly well placed to identify the companies and sectors that should be in the strongest position to perform in a variety of economic scenarios, including a prolonged economic downturn. As part of their assessment, our credit analysts consider all factors that could have an impact on a company’s financial performance, covering areas such as business risk (management, market position and product strategy, for example), financial risk (such as cashflow, debt and profit margins), bond structure, covenants and ESG factors.
Furthermore, while valuations in bond markets are stretched, an active manager has the flexibility to invest outside of traditional credit markets, for example in floating rate notes, ABS or covered bonds to generate returns. Global fixed income markets have grown significantly over the last decades. Growing to $145.1 trillion in 20241, bond markets have expanded to become a wider and more diverse universe. The corporate bond market in particular has seen a dramatic evolution, presenting investors with a huge variety of instruments to invest in today that didn’t exist 20 years ago. Often these instruments are not included in bond indices, so passive vehicles cannot tap into these portions of the market and therefore miss out on the diversification benefits or the additional structural protections.
A sell-off scenario
While uncertainty pervades the horizon, it is inevitable that at some point a market correction may occur. Market corrections often occur unexpectedly and rapidly. This offers opportunities for active managers to take advantage of improved valuations and buy into these assets, potentially creating an abundance of opportunities to capture value. Passive managers, on the other hand, do not have the flexibility to sell a position, whether due to a deterioration in its credit profile or simply on valuation grounds, nor can it step in to capture value in the same way an active manager can – passive vehicles are valuation agnostic. They tend to carry the same level of risk throughout the cycle.
During sharp market sell-offs, dislocations can occur between fixed income ETF prices and their underlying net asset values (NAVs). In these scenarios, ETFs can lag their underlying benchmarks as the market is unable to absorb large amounts of selling. During severe sell-offs, there have even been cases when ETF prices have fallen below their NAVs. Furthermore, unlike active managers, index funds are fully invested and therefore cannot hold cash and other liquid instruments to act as a buffer against market falls.
Passive vehicles may have benefited from the idiom that a rising tide will lift all boats, but with the perma-volatility that pervaded 2025 likely to continue into 2026, flexibility and rigour will likely be defining drivers of returns.
1 SIFMA, ‘2025 SIFMA Capital Markets Fact Book’, (SIFMA - sifma.org - Securities Industry and Financial Markets Association - Invested in America ), July 2025.”
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
