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Diversifying Your Bond Portfolio: Exploring Opportunities Beyond Investment-Grade Bonds

The rise in interest rates and relatively low prices of bonds compared to stocks have made bonds the asset class du jour for most investors over the last year. Billions have flowed into bond funds and portfolios as investors have continued to lock in yields and the potential for capital gains as the Fed cuts. There’s only one problem with all that buying — investors have continued to focus solely on investment-grade bonds.

While there is nothing wrong with the Bloomberg Aggregate Bond Index (Agg) or its global equivalent, investors who are simply focusing on the easy solution may be missing out on plenty of returns and yield potential. Thinking broadly and outside the box are best practices when it comes to fixed income and your portfolio.

Looking at the Agg

Tracing its origins back to 1973 with investment bank Kuhn, Loeb & Co., and its two early bond indices, the Bloomberg Barclays U.S. Aggregate Bond Index has grown to become the standard benchmark for the fixed income sector. And it’s easy to see why.

The Agg tracks the performance of the entire U.S. investment-grade fixed-income securities market, which is made up of a wide range of securities, including U.S. Treasury bonds, corporate bonds, mortgage-backed securities (MBS) and asset-backed securities (ABS). These bonds range in maturity from one year to over 20 years. As such, the average bond in the Agg has a maturity of around 8.6 years — putting it right in the middle of bond maturities.

Today, the Agg tracks over 10,000 different investment-grade bonds.

Given its size, average maturity and focus on the largest fixed-income market in the world, the Agg is seen by many bond investors as the proxy for the entire sector. Assets back up this theory. There are hundreds of billions of dollars benchmarked to the Agg via mutual funds, ETFs, SMAs and other investment vehicles.

For the first half of the year, more than $118 billion flowed into bond index funds tracking the Agg. Investors looking to play the rise in rates and the return of fixed-income securities have clearly chosen the Agg as their de facto leader.

Not So Fast

The problem for the Agg and the bonds in the index is several fold.

For starters, the index itself is heavily weighted in U.S. Treasuries. As a market-cap-weighted index, the Agg places more weight in its index on the largest issuers of debt. In the investment-grade world, this is the U.S. government. Moreover, that weighting has been getting larger as years have gone by. For example, back in 2000, U.S. Treasury bonds made up only 38% of the index. Today, that number is closer to 44%. This potentially underweights other opportunities within the index itself. 1

Despite being very large and holding over 10,000 bonds, the Agg doesn’t cover many types of bonds. These include municipal bonds (both tax-free and taxable), high-yield and non-investment-grade bonds, floating rate securities like those from the U.S. Treasury, senior loans, TIPS (Treasury Inflation-Protected Securities), emerging market bonds, and international bonds. It turns out that investors who ignore these other opportunities are missing out — not only in returns and yield, but also in terms of lower risk profiles as well.

Looking at the low-hanging fruit first, which is yield, investors have the opportunity to score higher yields in bond asset classes outside the Agg, which is heavily focused on U.S Treasuries. The below chart from Vanguard highlights current yields of the major bond asset classes and includes the Agg. As you can see, investors can grab much higher yield when compared to Agg.

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Source: Vanguard

At the same time, the credit quality of some of the asset classes can contain investment-grade issues as well. For example, many municipal bonds have credit quality that is better than the corporate bonds in the Agg but is nearly on par with the Treasury. And yet, munis yield more on an after-tax basis.

Additionally, you can see from the chart that many other bond asset classes have performed better than the Agg over the last year and the rise in interest rates. This plays into the idea that many other bond asset classes have lower durations that the Agg.

The Agg’s average duration is around 8.6. Duration is essentially how sensitive a bond’s price is relative to interest rates, both increases and decreases. When rates rise, bond prices fall as investors can buy new bonds with higher coupon payments. So, a bond with a duration of 2.5 years would see a 2.5% drop in price on a 1-percentage point increase in interest rates. With a higher duration, investors in the Agg may be subjecting themselves to more risk despite having a high credit rating. Better risk/return opportunities exist elsewhere.

Looking Beyond the Agg

Again, there is nothing wrong with the Agg as a portion of your portfolio. Including the index instantly adds diversification and a great core bond holding. The issue is that many investors simply stop there. They buy an ETF or index fund tracking the benchmark and then move on to other non-bond pastures. By doing this, they could be sacrificing yield and better returns. Investors can potentially benefit from adding additional assets, fixed-income asset classes and securities.

The proof is in the pudding. Looking at so-called multi-asset income and bond funds, asset manager BlackRock found that returns for these vehicles beat the long-term returns of the Agg by a wide margin while providing higher yields and less risk/drawdown.

The best part is that investors have a wide range of ways to increase their bond holdings. They can be tactical on their own and add asset classes like senior loans or munis through various low-cost ETFS, or they can take advantage of a professional. The number of active bond ETFs has continued to grow — with many now in the total or core plus bond categories. These mandates seek to outperform the Agg by adding all the other asset classes or by focusing on different pieces of the investment-grade pie.

Core Plus & Total Return Bond ETFs

These ETFs were selected based on their low-cost exposure to active bond management. They are sorted by their YTD total return, which ranges from -2.8% to 2.8%. They have expenses between 0.18% and 0.70% and assets between $3B and $23B. They are currently yielding between 4.4% and 9%.

In the end, investors who are simply just buying the Agg, or its global equivalent, are doing a big disservice to their portfolios. And yes, it’s the easy and most obvious choice for bond holdings, but it doesn’t mean it’s the best. In fact, by not expanding their universe, investors are leaving yield and potential returns on the table — and that’s a recipe for disaster.

Bottom Line

The Bloomberg Aggregate Bond Index (Agg) continues to draw billions in inflows as investors seek bonds for their portfolios. However, just buying the Agg may not be the best choice. Higher yields and better returns await those investors who look outside the box and expand their horizons.


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Jul 19, 2024