The bond market has a passive investing problem, and it’s getting worse
Passive investing has been one of the great successes of modern portfolio management. Buy the index, hold the index, and over time you own a slice of the market’s most successful companies, weighted by the market’s own judgment of their value. That logic has worked beautifully in equities.
It does not work the same way in bonds, and the gap between the performance of the two is becoming a real problem for anyone who assumes “the bond market” is a neutral, diversified holding.
Here is the mechanism most investors, and more than a few advisers, don’t spend much time on: equity indexes weight companies by market value, which reflects the market’s collective view of future earnings power. Bond indexes do something fundamentally different. They weight issuers by the amount of debt outstanding. The more a government or company borrows, the larger its weight in the index, regardless of valuation, credit quality or whether that borrowing makes any sense at all.
In other words, buying “the bond market” isn’t a bet on quality. It’s a bet on indebtedness.
A concentrated bet getting more concentrated
The Bloomberg U.S. Aggregate Bond Index – the benchmark most Canadian and U.S. bond funds are measured against – is roughly 70 per cent government or government-related debt, with a duration (weighted average time to receive coupon and principal) of about six years. Anyone indexing to it is making a large, concentrated bet on the world’s largest borrower, at precisely the moment that borrower’s issuance is accelerating.
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And it is accelerating. Annual U.S. Treasury deficits plus investment-grade corporate issuance averaged US$2-trillion to US$2.5-trillion between 2010 and 2016. By 2025, that figure had climbed to roughly US$3.5-trillion to US$4-trillion, and forecasts from JPMorgan combined with Congressional Budget Office projections point to more than US$5-trillion in annual issuance by 2030. Artificial intelligence is now adding its own layer of supply on top of that in the private sector: Amazon, Alphabet, Meta, Microsoft and Oracle alone issued about US$121-billion in corporate bonds in 2025 – more than four times their average annual issuance from 2020 through 2024 – making AI-related capital spending one of the largest single drivers of new investment-grade debt.
None of this is a comment on the credit quality of those issuers. It’s a comment on what happens to an index-tracking portfolio when the biggest borrowers keep getting bigger. Every dollar of new issuance from the most indebted names flows automatically into benchmark-huggers’ portfolios. Nobody voted for that allocation. It’s simply how the math of a debt-weighted index works.
Diversification isn’t a fixed property of bonds
The second problem compounds the first: the diversification benefit investors have always assumed bonds provide isn’t constant. It depends on which macro risk is dominant.
When recessions are the primary threat, falling rates support bond prices while equities fall, and so bonds do their job. But when inflation and fiscal risk dominate, higher discount rates pressure stocks and bonds at the same time. That’s precisely what happened in 2022, when the Bloomberg U.S. Aggregate Bond Index fell 13 per cent, its worst calendar year since the index’s 1976 inception, while the S&P 500 fell nearly 20 per cent in the same year. A 60/40 portfolio of stocks and bonds had nowhere to hide.
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That wasn’t a one-off. Research on long-run stock-bond correlations shows they were generally positive before 2000, turned negative through the low-inflation decades that followed, and have gone positive again as inflation re-emerged postpandemic. The IMF has reached a similar conclusion: bonds now offer less protection against equity selloffs than they did during the disinflationary era investors got used to. With U.S. CPI inflation currently running at 3.5 per cent, that’s not an academic concern, it’s the regime we’re in.
The results are visible in performance, not just theory. Through this past March, Canada’s largest traditional bond funds had produced cumulative five-year returns of only about 3 per cent – roughly 0.6 per cent annualized. For many investors, the 2022 drawdown alone erased years of coupon income, and it happened at the exact moment diversification was needed most.
What this means for portfolios
None of this is an argument against fixed income. Higher yields have restored real income to the asset class, and bonds still belong in diversified portfolios. It’s an argument against assuming a benchmark-oriented bond allocation is doing what advisers and clients think it’s doing.
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A debt-weighted index cannot avoid the most indebted issuers, cannot manage duration in response to the inflation regime, and cannot select credits based on valuation or fundamentals. By construction, it isn’t built to. An active manager can do all three: reduce exposure to the largest borrowers when their debt loads stop being compensated by yield, extend or shorten duration as the correlation regime shifts, and build credit exposure from the bottom up rather than accepting whatever the index hands out.
The question financial advisers should be asking clients isn’t whether fixed income deserves a place in the portfolio. It’s whether the passive, debt-weighted version of fixed income – designed for a 40-year period of falling rates and price-insensitive buyers that no longer exists – is still the right way to hold it.
Sandy Liang, CFA, is the head of fixed income at Purpose Investment Partners Inc.
