Passive investing has been widely embraced for its success in equity markets, allowing investors to buy and hold broad indexes weighted by market capitalization, which reflects the market’s valuation of companies. However, this approach faces significant challenges when applied to fixed income markets, where the mechanics of indexing differ fundamentally and are contributing to emerging risks for investors.

Unlike equity indexes, bond indexes weight issuers by the amount of debt they have outstanding, not by their credit quality or valuation. This means that the more a government or corporation borrows, the greater its representation in the index. Consequently, purchasing index-tracking bond funds effectively becomes a bet on the most heavily indebted borrowers, rather than on diversified credit quality.

The Bloomberg U.S. Aggregate Bond Index, a key benchmark for many North American bond funds, exemplifies this dynamic. Approximately 70 percent of this index is composed of government or government-related debt with an average duration of about six years. The largest component is U.S. Treasury debt, and issuance has been increasing sharply. Annual issuance of U.S. Treasuries combined with investment-grade corporate bonds averaged between US$2 trillion and $2.5 trillion during the 2010–2016 period. By 2025, this had grown to US$3.5 trillion to $4 trillion, with projections from JPMorgan and the Congressional Budget Office expecting it to surpass US$5 trillion by 2030. In the corporate sector, increased borrowing driven by artificial intelligence investments has added to supply; leading technology companies like Amazon, Alphabet, Meta, Microsoft, and Oracle issued over US$120 billion in bonds in 2025, quadrupling their average annual issuance from the previous five years.

This trend means that index-tracking bond portfolios are increasingly concentrated in the largest borrowers, automatically absorbing more debt from issuers with growing leverage, regardless of whether that debt represents prudent borrowing.

Adding to the concern is the changing relationship between bonds and equities. Historically, bonds have provided diversification benefits by rising in value when stocks fall, especially during recessions when rates tend to decline. However, when inflation and fiscal risks dominate, both equities and bonds can suffer simultaneously due to rising discount rates. This was evident in 2022, when the Bloomberg U.S. Aggregate Bond Index declined 13 percent—its worst annual performance since its 1976 inception—while the S&P 500 also fell nearly 20 percent. A standard 60/40 portfolio offered little protection in that environment.

Research shows that long-term correlations between stocks and bonds have fluctuated, tending to become positively correlated in periods of rising inflation, a trend seen again post-pandemic. The International Monetary Fund has noted that bonds currently provide less shelter from equity downturns than during the low-inflation era following 2000. With U.S. consumer price inflation around 3.5 percent, investors are operating in a regime where bond diversification benefits are diminished.

Performance data reflects these challenges. Through early 2026, major Canadian traditional bond funds delivered only modest cumulative returns over five years, with annualized gains near 0.6 percent. For many investors, losses experienced in 2022 erased years of coupon income precisely when diversification was most needed.

These developments do not argue against fixed income generally but caution against reliance on passive, benchmark-oriented bond strategies. Debt-weighted indexes do not allow portfolio managers to adjust duration in response to changing inflationary conditions, reduce exposure to the largest borrowers when yields no longer justify the risk, or select credits based on fundamentals.

Active management offers the flexibility to address these issues by managing issuer exposure, adjusting duration, and conducting credit analysis independent of index composition. For financial advisers and investors, the critical question is no longer whether fixed income should be part of portfolios, but whether passive bond strategies—designed for a long period of falling rates and abundant bond demand—remain appropriate in today’s market environment.