A major theme of 2023 has been the constant compression in volatility. In fact, the volatility index (VIX) is now lower than when the bear market began in January of 2022 despite the S&P 500 being about 10% below its all-time highs.

However, the consensus continues to be that these conditions won’t persist for too long. The longer that rates remain elevated at these lofty levels, the higher the odds that something breaks, causing a cascade of issues that will lead to a spike in volatility and a probable recession. According to Vanguard, a shallow recession remains likely to occur sometime early next year. 

For fixed income, it will certainly be challenging. So far this year, the asset class has eked out a small gain despite rates trending higher due to credit spreads tightening and low default rates. However, more volatility is likely if rates keep moving higher which would likely lead to selling pressure or if inflation does cool which would result in the Fed loosening policy, creating a generous tailwind for the asset class.

Given this challenging environment, active fixed income is likely to outperform passive fixed income as managers have greater discretion to invest in the short-end of the curve to take advantage of higher yields while being insulated from uncertainty. Additionally, these managers can find opportunities in more obscure parts of the market in terms of duration or credit quality. 

Finsum: Fixed income has eked out a small gain this year. But, the environment is likely to get even more challenging which is why active fixed income is likely to generate better returns than passive fixed income.