When it comes to interest rates and investing, two beliefs seem to prevail in the financial industry and the media. First, that recent interest rate hikes will benefit investors because they can expect higher returns in the long run. And second, that higher interest rates present greater opportunities for active bond fund managers to outperform. I―and my Vanguard colleagues―agree with the former. But whether we’ll see greater outperformance from active bond funds may depend more on the strategy their managers employ. 

In order to outperform competitors, active bond fund managers need to implement portfolio strategies that are different than those of their competitors. Default risk is key.

Analyzing performance through the lens of a risk factor model is a fairly standard way to assess strategy differentiation.¹ Aside from alpha, common factors include term risk (the return premium expected for owning bonds with relatively long duration), prepayment risk, and default risk. But have all these factors been consistent differentiators of long-term performance?

We analyzed the performance of bond funds across a 20-year period in five categories widely used by investors. Specifically, we estimated how much of the average monthly return difference between the top-performing funds (quartile 1) and the bottom-performing funds (quartile 4) in a fund category was driven by prepayment, term, or default factors.

The results of our research suggest that:

• The prepayment factor has not been a source of differentiation. The observations in our research concentrate around zero with little dispersion. This suggests that top-performing funds and bottom-performing funds could have similar allocations to bonds with negative convexity, such as mortgage-backed securities and other callable bonds.
• The term factor has been a minimal source of differentiation. The observations sit in a tight range, from –1 to +3 basis points, an indication that exposure to the term factor seems to have minimally differentiated the performance of funds within a category over the long term.
• The default factor has been the most consistently positive source of differentiation. Overall, each category’s observation is positive, ranging from 1 to 10 basis points. Also, each category’s default observation except for Short-Term Bond’s is greater than its term observation (e.g., the Intermediate Core category’s default value of 5.7 basis points is higher than its term value of 2.6 basis points). 

Our findings, illustrated in the figure below, suggest that default has been a greater differentiator than prepayment and term over the long term.

The analysis here provides a high-level assessment of some of the risk factor exposures that have differentiated top-performing active bond funds from bottom-performing funds in the same category.

While investors evaluate active taxable fixed income bond fund performance, they should take into account all three of these risk factors, but keep in mind that, at least historically, default risk has been the most consistent performance differentiator over the long term.

I’d like to thank Ning Yan for her invaluable contributions to this commentary.

• Actively managing negative convexity in muni bonds (article, issued September 2023)
• Munis, Fed policy, and negative convexity (article, issued August 2023)
• How experts identify small-/mid-cap growth leaders (article, issued August 2023)