In a world of ever lower interest rates and negative bond yields, investors are increasingly looking to the investment grade (IG) corporate bond markets to boost income. However, passive strategies may no longer provide investors with adequate compensation for the incremental credit risk they are taking. In this environment, an active approach to security selection could potentially add value.

Increasing credit risk is leaving passive investors vulnerable

Whether your portfolio allocation to investment grade corporate bonds is fulfilling its intended role may depend upon whether you take an active or passive approach to access this critical debt market.

Passive strategies, which aim to closely track IG corporate indices while minimizing costs, have been hugely popular with investors. However, cap-weighted indices give the greatest weight to issuers with the greatest amount of debt, so passive funds will, by default, be more concentrated in the most indebted issuers—not necessarily the most solvent. Also, passive funds have no room to maneuver if the overall credit quality of the index changes over time.

Over the last decade, for example, the credit quality of the Investment Grade (IG) Corporate Index has deteriorated, as companies have taken advantage of historically low interest rates to borrow more through the debt markets. As the amount of IG corporate debt outstanding has grown, credit ratings have dropped, with lower quality BBB rated issuers now accounting for nearly 50% of the market—up from just 25% 10 years ago.

Active, research-driven strategies use fundamental, relative value and technical analysis to identify the most attractive corporate securities from a risk-adjusted perspective rather than simply tracking an index. This means that active funds have the flexibility to respond to shifts in index composition by focusing only on those bonds that adequately compensate investors for the amount of risk that they are taking.

The recent deterioration in index credit quality and decline in credit risk compensation is a case in point. As credit rating agencies become more tolerant of higher leverage, proprietary research is diverging from official ratings—creating opportunities for active security selection. At J.P. Morgan Asset Management, our career analysts’ ratings differ from those of the rating agencies for about a sixth of the corporate bond market—with our research suggesting a lower credit quality than the rating agencies imply across roughly 12% of the index.

Looking ahead to active investment management

Fixed income investors are likely to continue to rotate down the quality spectrum to gain exposure to the higher yields provided by corporate bonds. However, the deterioration in credit quality and spread tightening seen across the broad IG corporate index means that investors are also likely to start requiring more compensation per unit of risk.

We believe an active, research-enhanced approach can reduce investors’ exposure to uncompensated risks, while adding value by identifying those securities that are likely to outperform. It’s this ability to distinguish the good from the bad that can help investors reap the full benefits of exposure to IG corporate bonds across the market cycle.

Style matters in today’s heightened credit risk environment

Investors do not need to suffer this rise in the uncompensated and unintended risks of passive corporate bond investing. We believe that in the hands of experienced, skilled managers, an active research-driven approach can provide superior solutions compared to passive investment styles.