As the bull market in U.S. equities continues, with the S&P 500^® up 18% YTD,¹ we have witnessed in parallel an extraordinary time in the fixed income markets. Historically low credit spreads have led to the outperformance of high yield bonds relative to corporate bonds and corporate bonds relative to Treasuries. The iBoxx USD High Yield Developed Markets outperformed the iBoxx $ Corporates by 2%, and the iBoxx $ Corporates outperformed the iBoxx $ Treasuries by 1% YTD.¹ Consistent with declining spreads, implied credit volatility has been muted. The CDX/Cboe NA Investment Grade 1-Month Volatility Index (VIXIG)² and CDX/Cboe NA High Yield 1-Month Volatility Index (VIXHY)² dipped below the 30 and 140 handles, respectively.

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But what do these conditions mean for fixed income active managers? We analyze the traditional sources of excess return, one of which is taking on higher term or interest rate risk, as measured by the returns of longer-dated bonds relative to shorter-dated ones. Another source stems from dipping down the credit spectrum toward investment grade or high yield corporates. A final key driver of excess returns comes from greater exposure to illiquid bonds, estimated by the return differential between high yield and investment grade indices and their liquid counterparts.

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As seen in Exhibit 2, a sharp reversal in the Term category’s excess returns from 2023 to 2024 meant that long duration tilts that would have rewarded managers in 2023 have hurt them so far this year. However, long-term high yield credit exposures continued to be accretive, with excess returns outpacing those of all other reported credit categories. In another reversal from last year, investors may have benefited from taking on illiquid exposures in the investment grade space.

Despite the availability of near-term opportunities to seek excess returns, most fixed income active managers have historically underperformed their benchmarks, particularly over longer horizons. In 2023, most Government funds underperformed across the yield curve. However, Investment Grade Intermediate and Investment Grade Short-Intermediate fund categories posted majority outperformance, as observed in Exhibit 3, perhaps benefiting from longer duration tilts outside the benchmark.

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While interest rate, credit and liquidity conditions for the second half of 2024 remain unknown, we can look to history as a guide. Understanding the sources of fixed income excess returns over time may help explain the likelihood of outperformance within the bond markets. For more information across all our reported fixed income categories, please refer to the SPIVA U.S. Year-End 2023 Scorecard.

¹ Data as of July 11, 2024.

² The CDX/Cboe NA Investment Grade 1-Month Volatility Index measures the market’s expectation of the range of movement in the CDX North American Investment Grade Index five-year spreads over the next one month

² The CDX/Cboe NA High Yield 1-Month Volatility Index seeks to track the market’s expectation of the range of movement in the CDX North American High Yield Index five-year spreads over the next one month.

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