Passive fixed income strategies may look efficient, but their structural flaws have long created opportunities for active managers to shine. In 2026, those inefficiencies could deepen as markets face rising government deficits, surging AI-driven capex, and a wave of bond issuance. This makes the case for active credit management more compelling than ever.
The baked-in inefficiencies of passive benchmark trackers have always provided a source of alpha opportunities for active fixed income managers. As investment risks and market dynamics evolve in 2026, the role of passive trackers as “observers”, and active risk managers as “navigators”, may become even more clearcut.
We start the year with an intriguing market backdrop. Competition for capital is heating up, government deficits are growing larger, and public credit markets will be tested with a wave of new supply from the broadening of AI-related investment.
The adoption and roll-out of AI technologies will drive a broadening of the capex cycle beyond technology sector investment and into areas such as networking infrastructure (telecommunications), energy capacity (utilities), data centre storage (real estate), as well as various manufacturing processes.
Traditional businesses in other sectors, with less existing rating headroom, may find that their bond supply requires a greater spread premium, which may lead to more yield spread volatility. Issuers may mitigate this by innovating bond features or their capital structure – hybrid issuance could grow further, and we may see renewable-linked financing for AI-energy projects. An active manager can take a risk-based view on this evolving capex cycle, especially as we gain insights into sector concentration and quantity of new issuance.
Finally, the rapid growth in private credit is expected to continue, and the news flow associated with this may contribute to a more volatile investment environment for wider credit markets.
With that in mind, how might investors go about successfully navigating such an environment? For us it’s a straightforward answer: those who want credit exposure should opt for an active manager. Here are four key reasons for choosing active over passive in fixed income.
Market-capitalisation construction bias
Market-cap weighting is a function of bond price multiplied by the amount of outstanding debt. This means that the most indebted issuers have the largest index representation – regardless of credit quality. Index tracking funds will replicate this exposure without adjusting for risk and be forced to build more exposure to the weaker names who issue more debt.
Index construction bias can also drive suboptimal trends at the sector level. For example, sectors experiencing rapid growth in leverage – for example, technology in 2001 or banks in 2008 – grow as a share of benchmark weight, leaving passive investors most exposed just at the moment of maximum crisis. As a sector de-levers during its recovery stage, its market-cap shrinks, and passive investors will also under-participate in the bounce back. A double whammy.
Credit rating inclusion rules
The most impactful index inclusion rule is based on credit rating. Most indices will differentiate between investment grade and high yield-rated securities, creating different index families for these two cohorts. Passive trackers often treat the two universes as different asset classes, which can lead to sub-optimal outcomes.
When a bond is downgraded to high yield (known as a “fallen angel”), it is removed from investment grade indices at the next rebalancing date (usually month-end). This forces passive funds to sell, regardless of price or fundamental outlook. This can lead to price dislocations if a wave of simultaneous selling by passive trackers occurs. Fallen angels often initially trade at depressed levels due to this index-induced flow.
Conversely, when a bond is upgraded to investment grade (a “rising star”), passive funds have to buy, often after the price has already appreciated. This can lead to momentum-driven price behaviour, which can benefit active managers who have anticipated such upgrades.
These passive flows are driven by rules, not fundamentals. Active managers can exploit this by avoiding forced selling and buying events and accessing fallen angels or rising stars at more opportune pricing moments.
The first step to outperforming in investment grade is avoidance of capital loss related to downgrade and default. Passive trackers will own all downgrades and defaults.
Uncontrolled turnover
Fixed income indices incur frequent turnover due to their inclusion rules (for example, credit migration) as well as new issuance and maturities. A global credit index typically experiences around 15%-25% average turnover per year. Index tracker funds will follow this rebalancing, incurring the associated transactional costs. Since indices are “frictionless” (ie their return calculations do not fully reflect the bid/offer spreads of buying and selling securities), tracking funds have a bias to structurally underperform their benchmark due to these costs and fees.
Active funds can choose which benchmark turnover events to participate in, and time their rebalancing ahead of potential index moves. The alpha generated by an active approach should offset the drag imposed by costs and fees.
Figure 1: A sample of passive fixed income ETF cumulative relative returns versus benchmark
Source: Bloomberg, largest ETF vehicles per asset class chosen (BNDX, LQD, JNK) as of 30 November 2025.
Risk factor stability: being passive can be inadvertent active call
A passive investor will not be able to readily control the evolving market risk/beta exposure of an index universe, which can trend through time with significant changes. Over the past 20 years, global credit benchmarks have seen a downward rating migration from AA/A to A/BBB, and index duration risk extend by up to two years in the post-Covid period. In short, benchmarks do not provide stable beta exposure.
Active management can help mitigate against trending risk factors and allow for pre-emptive consultation on how to adapt investment guidelines or return ambitions for changes in asset class dynamics.
In aggregate, the 2026 fiscal deficit for G7 governments is forecast to be 5.1% (according to Bloomberg consensus economic surveys). This will provide an additional test for bond markets – increased supply, deteriorating debt fundamentals, and the potential for government borrowing to crowd-out private sector borrowing.
The inflationary cycle post-Covid has brought duration risk into sharp focus. Many fixed income sectors – from corporate credit to emerging market sovereign bonds – have seen duration risk make a significant contribution to their total return outcomes (Figure 2). In order to optimise total returns for active portfolios, active duration and active yield curve risks should also be considered.
Figure 2: Duration evolution in fixed income indices (years)
Source: Bloomberg, ICE indices (G0BC, W0G1, WSBV) as of 30 November 2025.
The bottom line
Major fixed income indices are typically both market-capitalisation-weighted in terms of construction and have strict rules-based inclusion criteria. In passive trackers, these features drive inefficiencies such as forced buying and selling, an over-exposure to indebted issuers, and uncontrolled turnover. This results in performance leakage because costs and fees detract from index returns.
A typical investment grade borrower may have dozens of bonds outstanding. These bonds will vary in terms of maturity date, seniority within the capital structure, yield relationship to other bonds from the same issuer, and even in terms of currency denomination. This complexity is an opportunity for an active manager and should help a research-driven manager to deliver both superior total returns and a more efficient utilisation of risk.
Ahead of an uncertain outlook for global markets in 2026, the argument for working with active navigators rather than passive observers is compelling.
