October 31, 2023
Expectations in the new rate regime
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.
Our analysis of risk factors that drive long-term performance
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.
Default has been the most consistently differentiating risk factor
Average monthly difference (2003-2022)
Morningstar categories of bond funds
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: The chart displays the difference in average monthly return contribution from each factor for active fixed income funds in the top and bottom quartiles of 20-year annualized return for each Morningstar category (i.e., the mean monthly factor return multiplied by the difference between the median regression coefficient of quartile 1 and the median regression coefficient of quartile 4). The categories reflect bond fund strategies that invest primarily in U.S. dollar-denominated taxable fixed income securities that have maturities of greater than 1 year, that contain at least 15 funds, and that each have averaged at least 5% (and collectively account for more than 65%) of the assets under management in Morningstar’s U.S. Category Group of Taxable Bond over the relevant 10-year period. Each fund’s monthly return is calculated as the share class asset-weighted return. Factor coefficients are based on regressions of individual fund monthly net returns over the 1-month risk-free rate on term, default, and prepayment factors from January 2003 through December 2022. Term, default, and prepayment factors are defined, respectively, as the Bloomberg U.S. Treasury Aggregate Index total return minus the Bloomberg U.S. Short Treasury 1–3 Months Index total return; the Bloomberg U.S. Corporate High Yield Index excess return (versus duration-matched Treasuries); and the Bloomberg U.S. Mortgage-Backed Securities Index excess return (versus duration-matched Treasuries).
Sources: Vanguard calculations, based on data from Morningstar, Inc., and Bloomberg.
The takeaway for bond fund investors
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.
[1] See, for example, Mladina, Peter, and Steven Germani, 2019. Bond Market Risk Factors and Manager Performance. The Journal of Portfolio Management 45(6) 75–85.
Notes: Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. CFA® is a registered trademark owned by CFA Institute.