Bond Boss: when should you grab the steering wheel?

Passive investing is a bit like driving with cruise control. Choose your route, settle into your lane and let the car maintain its speed.

For equity investors, this approach can work well. Tracker funds are usually cheap, simple and transparent. No wonder bond exchange-traded funds, or ETFs, have become popular today too.

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But bonds are not shares with coupons attached. Their markets work differently, especially when trading becomes difficult.

Investors should know when to put their hands back on the steering wheel.

Why go passive?

A passive bond fund follows an index rather than trying to beat it. Investors receive broad exposure without paying a manager to make calls on rates, growth or individual borrowers.

Fees are generally lower, the approach is easy to explain, and performance has a clear yardstick. In liquid markets, that may be enough.

Passive investing is not a wrong turn, but you need to know whether the index offers the exposure you want and whether the fund can track it efficiently after costs.

When the biggest borrowers lead the index

An equity index usually gives its largest weights to companies with the greatest stock-market value. A conventional corporate-bond index gives its largest weights to issuers with the most eligible debt.

The more a company borrows, the more prominent it can become. That does not make it a poor investment, but the index reflects debt issued, not necessarily each bond’s appeal. A passive fund must broadly accept those weights.

However, an active manager can decide whether an issuer offers too little income for the risks involved or choose a more attractive bond from the same company.

That freedom matters. One company may have several bonds, each with a different maturity, yield, currency or ranking for repayment.

Tracking is harder than it looks

Bond indices can contain thousands of securities.

For example, a global investment-grade benchmark can contain more than 18,000 bonds, while a global high-yield gauge can feature more than 3,000.  Buying every bond in precisely the correct proportion would be difficult and expensive.

A passive tracker fund may only hold a representative sample. It must also handle new entrants, maturing bonds, rating changes and securities dropping out.

Trading adds friction. Corporate bonds are not generally traded on a central exchange like shares. Some trade regularly; others are costly to buy or sell.

Therefore, a tracker can lag its index net of fees, and often on a gross of fees basis. The gap may be modest in calm conditions. In a selloff, liquidity can disappear quickly. A passive fund must follow its rules even when a trade looks expensive.

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High yield: the bumpier road

Passive investing faces some of its biggest challenges in high yield, where issuers have lower credit ratings.

This market is less uniform, generally less liquid and with higher transaction costs than investment grade. The health of individual borrowers matters more, as does avoiding companies that may default. In high yield, steering clear of one major loser can sometimes be as important as finding several winners.

That does not mean active funds will always win. Managers can make poor decisions or charge fees that consume any advantage.

You should always ask how returns are generated, how risk is controlled and whether results justify the cost.

That said, bond selection matters. Yet the choice is not always simply passive or active.

A middle lane: systematic investing

The active-versus-passive debate is not always a two-lane road.

Some investors look for a middle ground: keeping the broad market exposure associated with passive investing while seeking improvements in returns.

This is where systematic investing comes in.

Think of it as active investing with a detailed rulebook. Rather than relying on big market calls, systematic strategies use a consistent framework to identify bonds that look more attractive than their peers.

The aim is not to stray far from the market investors signed up for, but to make a series of small, disciplined decisions that may add value over time.

For investors who like the transparency of a tracker but want something more than pure index exposure, it is another route worth considering.

Like any investment approach, results are not guaranteed and some signals will work better in certain market conditions than others.

So, passive, active or a bit of both?

Passive bond funds can suit investors seeking inexpensive, diversified exposure to a liquid market.

Active management may have a stronger case where liquidity is patchy, bond selection matters and avoiding weaker borrowers can be as important as finding stronger ones.

For investors who do not see the debate as an either-or choice, systematic strategies sit somewhere between a traditional tracker and a conventional active fund.

Ultimately, the best approach depends on what you want your bond portfolio to do.

Cruise control is useful on a clear, open road. But when the surface becomes uneven, it pays to know who is steering.