Most investors have a portion of their portfolio devoted to fixed income investments. For decades, the traditional ’60/40 portfolio’ has long been used as a guidepost for a moderate risk investor—a 60% allocation to stocks for capital appreciation and a 40% allocation to fixed income for income and risk mitigation.

One key component of your fixed income allocation should be an active bond fund.

What Are Active Bond Funds?

A bond portfolio can be managed in several ways. The primary methods are active, passive, or a hybrid of the two. Active bond portfolio management simply means that a professional manager takes an active role in the running of the bond portfolio.

Active management of bond funds involves portfolio managers who seek out bonds that are high performing and that they believe are more likely to surpass a benchmark index performance over time. 

The ultimate goal is to create and manage a fund that performs at or above the index, including identifying and investing in bonds that are undervalued. Active bond portfolio management may also involve buying bonds that hedge against movements in interest rates.

Active managers can adjust their funds’ average maturity, duration, average credit quality, and position among the various segments of the fixed income market.

Why Invest in Active Bond Funds?

A major advantage is that an active manager controls the holding period of the bonds. All bonds come with a maturity date. Passively managed funds typically hold a bond until it matures. In an actively managed fund, however, the manager can benefit the fund’s investors by selling off bonds with a lower yield and shorter duration.

When interest rates rise, selling off such bonds boosts the yield of the portfolio overall, reducing the interest rate risk to investors. Generally speaking, bonds can be invested in more profitably by selling them at advantageous times in the interest rate cycle that occur prior to maturity.

In addition to the aforementioned interest rate risk, active bond managers can also help investors alleviate the greatest risk for bond investors – credit risk.  That’s the risk that occurs if an issuer fails to pay interest or principal on its debt. The warning signs will be clear as an issuer’s financial condition deteriorates, causing rating agencies to downgrade the rating on an issuer’s bonds.  The active manager can sell these bonds. With a passive bond fund, you’re stuck with these bonds.

In simple terms, an active bond fund manager can intentionally adjust the levels of credit and interest-rate risk to improve the performance of their bond portfolios. These capabilities allow active managers to add value in a wide range of market conditions. This flexibility is especially valuable when market conditions have introduced increasingly high levels of credit and interest-rate risks. 

This flexibility is not possible for passive funds.

Examples of the “flexibility” active bond managers have include: adding value by including smaller issuers in their portfolios; buying variable rate securities, such as floating-rate notes or hybrid securities (fixed-to-floating rate notes) to benefit from changes in interest rates; adding allocations to inflation-linked bonds, such as U.S. Treasury Inflation Protected Securities (TIPS); take advantage of opportunities in shorter-maturity bonds, which carry much less interest-rate risk than longer-maturity bonds; and, when conditions warrant, add bonds rated below investment grade to enhance portfolio performance.

Of course, if you invest in an active bond fund, you do take the risk that the manager may underperform the bond benchmark indexes.

How to Invest in Active Bond Funds

Active bond funds – mutual funds and ETFs – can be bought just as easily as stock funds through any brokerage firm.

Such funds are gaining popularity. Through September 2021, Morningstar data showed that investors poured $330 billion into active-bond-funds in 2021. That was over $100 billion more than the $215 billion they put into passive fixed income funds.

Your search for the right active bond fund can be made much easier by using Magnifi, a search-based investing platform that can help match investments to your goals. Magnifi’s AI driven system finds investment suggestions for you based on just a few inputs of your data, such as risk tolerance and investment time horizon. 

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The information and data are as March 1, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi. 

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