• When rates change, active bond fund managers may alter their approaches to duration and credit risk to adapt to the new era.
• The risk profiles of active bond funds may also shift when interest rates are changing, as managers pursue their objective of outperforming their benchmarks.
• Investors should be aware of the risks that active bond managers take in different rate environments and make sure to consider these risks as part of their regular investment review process.

Interest rates have changed dramatically since 2022. As a result, investors may find that risk profiles in active bond funds also shift as active managers pursue their objective of outperforming their benchmarks in new rate environments. That makes this historic period of interest rate moves a smart time for investors to check the risk profiles of their bond funds.

We expect interest rates to remain relatively high compared with those since the 2008 global financial crisis, even if the US Federal Reserve (Fed) and other central banks continue to cut interest rates as expected. It marks a major change from the low-interest-rate environment that investors experienced from 2008 through to 2022, when it was likely that fund managers increased their credit risk exposure to “reach for yield”. 

Then, between early 2022 and late 2023, investors experienced sharp rate increases - including the largest rise in the 10-year US Treasury rate since 1981. 

When rates change, funds’ investment objectives remain the same, but fund managers may alter their approaches to duration and credit risk to adapt to the new era. Just because an investor holds the same fund, it doesn’t mean risk exposures remain static.  Investors should keep an eye on the impact that changes to interest rates can have on a fund manager’s duration and credit strategies.

Credit risk and duration risk tend to diverge

We analysed the risk profiles of actively-managed US bond funds relative to their benchmarks, based on fund-level monthly returns from 1990 to 2023. The results suggest that the relative credit risk of actively-managed bond funds decreases as rates rise. Interestingly, we found that the active funds’ relative duration risk was only statistically significant when rates were in the highest quintile over the time period (4.7%-6.1%).

When rates are lower, credit risk in active bond funds can be higher

Sources: Vanguard calculations, using data from Morningstar, Bloomberg and FRED (US Federal Reserve Economic Data), for the period 1 January 1990 to 31 December 2023. Based on an analysis of the 15 largest bond fund strategies that invest in US dollar-denominated fixed income securities. See footnote for more information¹.

Key takeaways 

An informed approach to active investing involves understanding the risks taken by active fund managers in different economic and financial environments. Some active bond fund investors may have grown accustomed to the risk profiles of their funds during the prolonged low-rate period from 2008 until the central bank hiking cycles began in 2022.

There are likely to be long-term benefits to bond fund investors from higher interest rates. Being aware of changes in duration and credit risk in active bond funds in this new environment can assist investors in maintaining an informed investment plan that instills discipline and increases their likelihood of investment success. 

Checking the risk profile of actively-managed bond funds is good practice as market environments evolve. Investors should be aware of the risks that portfolio managers take in different interest rate environments and make sure to consider these risks as part of their regular investment review process.

¹ Outlined bars indicate results that were not statistically significant. Data for the period from 1 January 1990 to 31 December 2023. The chart displays the risk exposures of actively-managed bond funds relative to their Morningstar benchmarks across five interest rate quintiles from 1990 to 2023. The sample reflects the 15 largest bond fund strategies that invest primarily in US dollar-denominated fixed income securities, collectively accounting for more than 95% of the assets under management (AUM) in Morningstar’s US Taxable Bond category group over the relevant period. To assess the risk exposures of these funds, we calculated the average net return of the active funds each month, weighting by their AUM at the end of the previous month. These monthly asset-weighted returns were then categorised into interest rate quintiles, based on the monthly average of the interest rate of the 10-year constant maturity US Treasury during that month. In each quintile, we regressed the monthly asset-weighted returns, adjusted for the 1-month risk-free rate against duration risk, credit risk and prepayment risk factors. Duration, credit and prepayment factors are defined, respectively, as the Bloomberg US Treasury Aggregate Index total return minus the Bloomberg US Short Treasury 1–3 Month Index total return; the Bloomberg US Corporate High Yield Index excess return (versus duration-matched US Treasuries); and the Bloomberg US Mortgage-Backed Securities Index excess return (versus duration-matched US Treasuries). Similarly, we assessed the risk exposures of these funds’ benchmarks by regressing the asset-weighted Morningstar category benchmark returns of each month—where weights are determined by the asset sizes of respective categories of active funds of the same month—adjusted for the 1-month risk-free rate, against duration risk, credit risk and prepayment risk factors. The differences between these risk factors’ coefficients (i.e., risk exposures) for the active fixed income funds and their benchmarks were calculated for each interest rate quintile. Solid bars in the chart indicate a statistically significant difference (p-value below 10%). This article only discusses results on credit and duration risk exposures, as the active funds did not consistently exhibit statistically significant exposures to prepayment risk.  

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