Is Your Bond Index in Trouble?
When it comes to core fixed income, the universal benchmark is the Bloomberg Barclays U.S. Aggregate Bond Index (“the Agg”). Many investors simply accept the index at face value and may not be aware of—or acknowledge—potentially significant risks that have developed as a byproduct of its construction.
Altered Risk Profile
Since the Agg is a market-value-weighted index, its components with greater levels of debt receive larger allocations to the index. Keep in mind that in wake of the financial crisis, the U.S. Government, in hopes of stimulating the economy, increased its issuance of Treasurys at low interest rates. Consequently, lower-yielding Treasurys now represent a (too-) large portion of the Agg, and the yield has declined significantly when compared to historical norms.
Figure 1: Lower Yielding Treasurys Have Overrun the Agg
U.S. Aggregate Index: Yield
Source: Bloomberg, 3/17/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Yield to Worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. Calculated by making worst-case scenario assumptions on the issue by calculating the returns that would be received if any in-whole mandatory redemptive provisions are exercised by the issuer. Partial redemptive provisions (such as sinking funds) are not included in Yield-to-Worst calculations. The Yield to Worst metric is used to evaluate the worst-case scenario for yield to help investors manage risks and ensure that specific income requirements will still be met even in the worst scenarios.
While yields have dropped significantly on the index, the overall duration has lengthened, meaning that investors benchmarked blindly to the Agg are overexposed to interest rate risk, in exchange for a lower coupon.
Figure 2: Longer Duration Equals Overexposure to Interest-Rate Risk
U.S. Aggregate Index: Duration
Source: Bloomberg, 3/17/17.
Non-Core Fixed Income Can Help with Diminishing Opportunities
While the term “Aggregate” may suggest an all-encompassing nature, truth be told, other fixed-income sectors, such as high-yield bonds, bank loans, and convertible securities, are not represented in the Agg. Roughly speaking, the Agg accounts for only around 50% of the U.S. fixed-income universe.
It’s true that over the last 10 years, those who have benchmarked their fixed-income allocations to the Agg have performed reasonably well, but that may not hold true, given its altered risk profile. To compensate for the added risks, investors may be well-served by supplementing their core fixed-income exposure with non-core fixed-income sectors, such as high-yield bonds, or even looking abroad at foreign bonds.
Figure 3 highlights strong fixed income-performance characteristics found beyond the scope of the Agg.
Figure 3: Opportunities Beyond the Agg
|Within the Aggregate||Outside the Aggregate|
|U.S. Aggregate Index||Investment-Grade Corporates||Mortgage Backed||Short-Term Treasuries||Intermediate-Term Treasuries||Long-Term Treasuries||High-Yield Bonds||Emerging Market Debt|
Source: Morningstar. Calendar year returns are highlighted on a color scale of highest (green) to lowest (red). The chart shows that in many calendar years, the highest returns occurred in fixed-income sectors not held within the Agg.
By introducing non-core components that are currently left out of the Agg, investors can potentially extend their yield opportunities, and simultaneously, manage their duration exposure. While these non-core sectors each carry their own inherent risks, diversification can help to manage some of those effects.
Figure 4: Diversification Beyond the Agg
Yield and Duration
Source: Morningstar. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
For example, sectors, like high yield, offer diverse sources of potential return by relying more on credit spreads and less on the overall direction in interest rates. High-yield bonds have historically displayed attractive performance during periods of rising interest rates.
Figure 5: Rising Rate Periods Have Historically Been Good for High Yield
Source: Morningstar. Period 1: 10/31/98 – 1/31/00. Period 2: 6/30/04 – 6/30/06. High-Yield Bonds are represented by the Bloomberg Barclays U.S. High Yield Very Liquid Index (VLI). Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
A simple buy-and-hold approach to the Agg may not be the most prudent approach in a rapidly changing fixed-income environment. Expanding the universe of sectors within a core fixed-income allocation has the potential to help enhance returns and diversify risk.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise. Bonds are subject to credit risk and interest rate risk.
There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
The Bloomberg Barclays US High Yield Very Liquid Index (VLI) is a component of the US Corporate High Yield Index that is designed to track a more liquid component of the USD-denominated, high yield, fixed-rate corporate bond market. The US High Yield VLI uses the same eligibility criteria as the US Corporate High Yield Index, but includes only the three largest bonds from each issuer that have a minimum amount outstanding of USD500mn and less than five years from issue date. The index also limits the exposure of each issuer to 2%.
Yield is the annual rate of return on an investment, based on the purchase price of the investment, its coupon rate and the length of time the investment is held. The yield of a municipal security moves inversely to the price.
The coupon rate is the periodic rate of interest, usually calculated as an annual rate payable on a security expressed as a percentage of the principal amount. The coupon rate, sometimes referred to as the “nominal interest rate,” does not take into account any discount or premium in the purchase price of the security.
Duration is the measure of the timing of cash flows (i.e., the interest payments and the principal repayment) to be received from a given fixed income security. Duration is used to assess price volatility for given changes in interest rates, the reinvestment risk associated with a given portfolio or the interest rate risk associated with matching particular interest-rate-sensitive assets and liabilities.
In Figure 4:
Short-Term Treasuries are represented by the Schwab Short-Term US Treasury ETF (ticker SCHO). The ETF is based on the Bloomberg Barclays
S Treasury 1-3 Year Index – The index measures the performance of U.S. Treasury securities that have a remaining maturity of at least one year and less than three years.
Intermediate Treasuries are represented by the Schwab Intermediate-Term US Treasury ETF (ticker SCHR). The ETF is based on the Bloomberg Barclays US Treasury 3-10 Year Index. The index measures the performance of Treasuries with a maturity of more than three years and less than ten years.
Long-Term Treasuries are represented by the SPDR Bloomberg Barclays Long Term Treasury ETF (ticker TLO). The ETF is based on the Bloomberg Barclays US Treasury Long Index. The index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
IG Corporates are represented by the iShares iBoxx Investment Grade Corporate Bond ETF (ticker LQD). The ETF is based on the Markit iBoxx Liquid Investment Grade Index. The index measures the performance of 600 highly liquid investment grade corporate bonds.
Mortgage Backed is represented by the iShares MBS ETF (ticker MBB). The ETF is based on the Bloomberg Barclays US MBS Index. The index measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC.
High Yield is represented by the SPDR Bloomberg Barclays High Yield Bond ETF (ticker JNK). The ETF is based on the Bloomberg Barclays US High Yield Very Liquid Index (VLI). The US High Yield VLI uses the same eligibility criteria as the US Corporate High Yield Index, but includes only the three largest bonds from each issuer that have a minimum amount outstanding of USD500mn and less than five years from issue date. The index also limits the exposure of each issuer to 2%.
Emerging Markets are represented by the iShares JP Morgan USD Emerging Markets Bond ETF (ticker EMB). The ETF is based on the JP Morgan EMBI Global Core Index. The index is a broad, diverse U.S. dollar denominated emerging markets debt benchmark that tracks the total return of actively traded debt instruments in emerging market countries.
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