Built to lag? The trouble with passive bonds

Providers of passive index-tracking strategies often market them as giving investors access to the full breadth of specific opportunity sets via investable indices. Because passive portfolios should hold everything included in an index, it’s claimed investors will get good diversification. And because the composition of passive portfolios changes only if and when the corresponding index changes, that should keep turnover and transaction costs low. Management fees are inexpensive too: investors are paying for computer algorithms, not people, to choose where to park their money.

But the way bond indices are built means they can have serious limitations as proxies for the investable opportunity set or the basis for passive portfolios.

Weighted by debt, not quality

Equity indices are weighted by market capitalisation so they do a pretty decent job in representing all the most valuable securities within their particular market segment. The FTSE 100, for example, will always include the UK’s 100 biggest public companies. But bond benchmarks rely heavily instead on issue size and/or the amount of debt outstanding.

The biggest borrowers have the heaviest weightings in bond indices. Some of the world’s most successful businesses carry large debt loads. But passive investing in corporate bonds can increase exposure to issuers with higher leverage and declining credit quality and even, as we’ll explain later, substantial interest rate-risk. That can mean concentrated exposures and potentially increased risks since it guarantees passive portfolios are overloaded with the most indebted borrowers.

The same methodology that determines that individual issuers’ index weighting is driven by how much they borrow applies at the sector level too. The UK’s water utilities are heavy borrowers, so the sector accounts for more than 8% of the UK sterling corporate bond indices, guaranteeing passive investors hefty exposure to an industry rarely out of the headlines for all the wrong reasons.

Avoiding blow-ups matters enormously in bonds. Their asymmetric return profile (best case, you get your income payments and your principal back at maturity; worst case, you lose both) means you can gain more by avoiding the worst losers than from picking the best winners. Passive portfolios, locked into owning every eligible issuer, can’t shield themselves from the next Thames Water. Don't assume passive is a safer bet – in corporate bonds, it can be riskier.

Default risks aren’t the only concern. We assess myriad other factors too, notably valuations, liquidity, concentration risks and how changes in the structure of bond markets might affect future returns.

Right now, the extraordinary AI-driven borrowing boom is top of our watchlist. This issuance has surged from almost nothing in late 2024 to an estimated $500 billion in the first nine months of 2026 alone. Some estimates suggest it now accounts for around a quarter of total new bond issuance globally.

That means passive investors are being pushed into ever-greater exposure to a single investment theme as AI-related debt becomes a larger part of benchmark indices. And, because much of this borrowing has been issued at long maturities, it’s extending the duration of major corporate bond indices, thereby increasing the interest-rate sensitivity of the passive portfolios that track them.

A poorer opportunity set?

Active investment managers aren’t forced into any of this. We can choose which issuers we believe offer the most attractive opportunities rather than simply loading up on the biggest borrowers. And we can choose which of an issuer’s bonds we want to own. A single corporate borrower may have dozens of bonds outstanding, with different maturities, currencies and positions in the capital structure — senior debt sits nearer the front of the repayment queue, subordinated debt further back. Each trades independently, and the relative value between them can be significant; we might, for example, capture a higher yield at a cheaper price by buying a large issuer’s more subordinated debt.

Passive portfolios are also boxed in by the eligibility rules that exclude large parts of the investable universe from benchmark indices. Bonds with less than 12 months to maturity are excluded, as are floating-rate notes and many of the so-called ‘legacy’ bonds that banks and insurers issued to shore up their capital after the Global Financial Crisis. These can carry sizeable coupons and their issuers often buy them back on generous terms. It makes little sense that passive portfolios hold large slugs of banking and insurance debt yet exclude potentially the most attractive bonds in the sector.

Currency is another blind spot. A UK issuer might borrow in dollars because it's cheaper or in demand from US investors. Those bonds are excluded from sterling indices, so passive portfolios can’t touch them, while active managers can pick up attractive excess yields when the opportunity arises.

Duration drift

Track an index and you’re locked into whatever duration (interest-rate) risk it happens to carry. Think of duration as the rail track guiding your credit exposure engine. The quality of the engine matters, but so does the track’s direction. If interest rates rise sharply, even a portfolio full of solid corporate bonds may struggle if it’s stuck on a long-duration track. Conversely, when yields fall, longer-duration bonds can benefit from a powerful tailwind.

Active managers can adjust both the engine and the track, choosing not only which credits to own but also how much interest rate-risk overall they take and dynamically changing that exposure as the rates outlook changes.  

Buying high, selling low

Every investor shares one ideal: buy low, sell high. Yet the way passive corporate bond portfolios are built can lock investors into doing just the opposite. The culprit is a set of rigid, rule-based mechanics that force passive strategies to buy and sell at the worst possible moments, creating price dislocations that active managers can exploit.

The single most impactful rule is the credit rating cut-off between investment grade (rated BBB- or above) and high yield bonds (rated BB+ or below). Most index families treat the two as separate asset classes so a small ratings change can flip a bond from fully in an index to fully out.

When a bond gets downgraded from investment grade to high yield (becoming a so-called “fallen angel”), it’s kicked out of investment grade indices at the next rebalancing, usually month-end, forcing passive funds to sell regardless of price or fundamentals. Fallen angels’ spreads tend to widen ahead of a downgrade and then to tighten again after it: the downgrade point is close to the worst possible time to sell. Fallen angels rarely default, yet passive investors, unable to sell early or hold on, tend to lock in a capital loss at the bottom.

The rule cuts the other way too: investment grade indices only include bonds once they get an investment grade-rating, so passive portfolios miss the so-called “rising stars” improving their way up from high yield. Spot one before it’s upgraded and you can benefit from the price appreciation that follows.

Take the example of Coventry Building Society’s takeover of Co-Op Bank a couple of years ago. We felt the deal would lead to Co-Op’s bonds, which were high yield-rated ahead of the takeover announcement in May 2024, getting upgraded. So we sold some Coventry bonds we already owned to buy some roughly equivalent Co-Op ones which traded at a nice discount to the former. That meant we were able to benefit from the decent appreciation in the Co-Op bond prices as they were upgraded and became investment grade index-eligible in December 2024. By contrast, passives couldn’t buy the Co-Op bonds until their prices had already risen.

The common thread here is that passive flows are driven by rules, not fundamentals. Passives are forced buyers of rising stars just as their prices crest, and forced sellers of fallen angels just as their prices trough. Active investment managers, by contrast, can choose when and why they buy or sell - holding a downgraded bond through a recovery or getting ahead of an upgrade.

Then there's the primary market. New bonds typically launch at a slightly higher yield than an issuer’s existing debt, offering investors a sweetener to ensure the deal gets away. They then ‘trade up’ once trading begins, handing an immediate gain to whoever bought at issue. Passive portfolios can’t capture this new issue premium: they only buy once a bond enters the index, often weeks later and after its price has firmed. Global new bond issuance dwarfs global equity issuance each year (in 2025, it hit $29.9 trillion compared with $537.8 billion in new equity issuance). With so much primary supply, the new-issue premium can be a consistent source of alpha that passive strategies routinely leave on the table.

Bonds mature; equities don’t. That means bond indices experience much higher turnover (typically 15%–25% a year) than their equity counterparts. Every maturity, new issue, call or rating migration means passive strategies must trade to keep up, incurring transaction costs that the benchmark itself does not. This creates a built-in tendency for passives to lag the indices they track.

Trackers that don’t actually track

Most bond benchmarks contain tens of thousands of securities, many of which seldom trade. That makes it effectively impossible for a passive portfolio to buy them all. Instead, they rely on ‘sampling’ - holding a representative subset intended to mirror the index. But no sample is perfect. Small differences in credit quality, duration, maturity and liquidity can all contribute to tracking error, meaning a passive fund may not always fully replicate the performance of the benchmark it’s trying to follow. Active managers deliberately seek a positive tracking error to generate benchmark-beating returns. Passives, by contrast, seek to minimise their tracking error, but the complexity and relative illiquidity of bond markets means divergence from the index is often unavoidable.

That's why headline fees can be a poor guide to the true cost of passive investing. A fund charging 0.1%, but trailing its benchmark by 0.25% yearly is effectively costing investors 0.25% each year. That difference suggests that around 0.15% could be being lost to the hidden costs of index replication.

The uncomfortable truth is that replicating a bond index requires a significant amount of active trading. High turnover and liquidity constraints mean passive fixed income often amounts to actively trying to deliver index-like returns, with mixed results.

If you’re effectively relying on active decisions anyway, why accept the risks and limitations created by benchmark construction when you could invest in a strategy designed to make deliberate choices in pursuit of better outcomes?