Investors relying on passive bond funds may have missed out on significant returns over the last five years, according to recent research. This study suggests that such investors have been unable to capitalize on ‘rising stars’ or steer clear of ‘fallen angels’ in the bond market.

As both government and corporate bond markets brace for potential upheaval, active fund manager Rathbones has presented data supporting its active investment strategy. The firm has pinpointed 119 ‘fallen angels’ and 83 ‘rising stars’ within the corporate bond sector over the past five years, highlighting missed opportunities for passive index-following investors.

‘Fallen angels’ refer to bonds that were originally considered ‘investment grade’ but have since had their credit ratings downgraded to ‘junk’ status, indicating a higher risk of default. This downgrade can significantly impact the bond’s appeal to investors.

Conversely, ‘rising stars’ are bonds that have seen an improvement in their credit ratings, thus being perceived as less risky and more stable investments. This upgrade can make them more attractive to cautious investors.

The credit rating of a bond plays a crucial role in determining the yield investors would require to hold it. Bonds from companies perceived as high-risk will demand higher yields to compensate investors for the increased possibility of default.

A bond’s credit rating heavily influences the yield that investors will demand to hold it. If a company is considered more likely to default, investors will want a higher income to reflect the extra risk.

 For bonds that are already trading, this means a credit downgrade can see their price fall, with investors only willing to pay a price for the bond that will see them adequately rewarded.

Passive funds track indices and only rebalance at certain times meaning they can miss corporate credit rating upgrades and downgrades

An active fund manager can react quickly to a shift in a company – or government – credit rating. Passive funds, however, track indices and tend to rebalance every month or quarter, meaning that they will be left holding bonds facing downgrades over that period. 

Passive funds do tend to prove a much cheaper option for investors thanks to lower fees.

Rathbones says passive funds also often have to sell fallen angels within a set time frame, which can cement losses.

Bryn Jones, head of fixed income at Rathbones, said: ‘Active management offers the flexibility to act decisively.

‘We can sidestep deteriorating issuers before the index reacts, capture rising stars early, manage liquidity in volatile markets, and ensure portfolios align with ethical values in today’s fast-moving credit environment.’

The vast number of bond upgrades and downgrades comes as result of higher geopolitical and economic uncertainty since 2025.

In 2020, for example, a year plagued by the effects of the Covid pandemic, 46 companies saw their corporate bond ratings downgraded. 

In 2024, on the other hand, some 31 companies saw their bonds upgraded.

Rathbones says only active fund managers are able to capitalise on the opportunities created by these shifts.

It says active managers can identify bonds whose fortunes are changing, moving away from fallen angels and capitalising on rising stars.

Alex Watts, senior investment analyst at Interactive Investor, said: ‘Within the fixed income market, the massive volume of individual bond issuances on offer, can make for inefficiencies that aren’t so prevalent in the equity market and, theoretically, can make for greater opportunity for skilled active managers to generate outperformance if they overcome the hurdle of a typically higher fee.’

Passive funds miss out on rising stars – corporate bonds that aren’t yet investment grade but have strong potential. They can only purchase bonds when they enter the index they track, at which point most of the potential for improvement has been priced in.

Darius McDermott, managing director at Chelsea Financial Services, told This is Money: ‘At turning points when markets are deeply irrational, active management adds real value.’

He added: ‘While passive bond funds could rally if government bond yields fall, that could be unlikely against a backdrop of rising debt burdens, political instability and the Trump Administration’s continued pressure on institutions like the Fed.

‘If yields move back towards 1990s levels, many will keep burning capital. 

‘That’s why, in our funds, we only ever use passive vehicles for basic government bond duration. We would never buy passive credit or high yield – those are areas where active management is essential.’

Passive funds are also at higher risk of suffering if  the bond market crashes, as it did in 2022.

McDermott said: ‘The 2022 bond market rout, triggered by the surge in inflation and interest rates , should be a warning to all passive investors. 

‘Passive funds bought bonds with negative yields simply because they were in the index, something any rational active manager would have avoided.’

While not all active managers are guaranteed to make the right call during a crisis in the market, they still have defence mechanisms at their disposal to shift their holdings away from risky areas – something that passive funds cannot do. 

Active funds will cost you more 

Of course, active management also comes with a considerably higher price tag, and this can significantly eat into an investors pot, especially if you aren’t getting returns.

The Rathbones Ethical Bond Fund, for example, has an ongoing charge of 0.64 per cent, compared with just 0.15 per cent for Vanguard’s Global Bond Index Fund.

Watts said: ‘If you’re happy paying more to potentially outperform the index through the skill of an active manager supported by a large research resource, you may consider a fund such as the Pimco GIS Global IG Credit fund (ongoing charge 1.42 per cent) managed by Mark Kiesel.’

McDermott tips Aegon Strategic Bond Fund (ongoing charge 0.5844 per cent) which he says is ‘highly active and flexible’, as well as Rathbone Ethical Bond Fund (ongoing charge 0.64 per cent). 

However, Wadds added: ‘If low-cost is your goal, select an appropriately well-priced option, such as the Vanguard Global Bond Index Fund, which tracks the Bloomberg Global Aggregate Flat Adjusted and Scaled index of over 20,000 IG and government issuances for a fee of just 0.15 per cent.’

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