Investors Deserve a Peek at Bond Managers’ Tricks

Active bond managers have dazzled investors by outpacing the bond market in recent years. But it’s a simple sleight of hand, and the big reveal is coming.    

The trick is that bond managers have been quietly loading up on low-quality bonds. They pay a higher yield than top-quality ones to compensate for their greater risk of default — in technical parlance, a credit premium.

When times are good, as they have been in recent years, there are few defaults because borrowers have little trouble paying their debts. Bond managers collect their credit premiums and easily beat the broad bond market indexes, which tend to be dominated by high-quality bonds.

When the economy slows, however, the defaults start to pile up, handing losses to holders of low-quality debt. And suddenly bond managers don’t look so smart.  

It’s a worthwhile trade-off for managers. The booms normally last longer than the busts, which means that credit premiums are usually a boost to performance. And nothing attracts investors like a hot hand, or the appearance of one.

But it’s not great for investors. They often don’t realize that their bond manager is taking more risk until the losses show up. And investors who want riskier bonds can almost always buy them more cheaply through index funds. They would be better served by a closer inspection of bond managers’ tricks of the trade.

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