Following extraordinary – but familiar – monetary policies, we find ourselves back in a zero interest rate policy era. That makes income generation more difficult, as the yield of the standard 60/40 portfolio is now the lowest on record.1
Basic bonds now yield 60% less than traditional stocks do – the largest yield discount on record.2 Therefore, generating more income requires investors to take on more fixed income risk — either duration, credit or currency.
Portfolio construction of the fixed income core has likely never been more important than it is today. Unfortunately, the composition of the Bloomberg Barclays US Aggregate Index (the Agg), a common core exposure, leaves it vulnerable to duration risks. Also, the Agg does not produce sufficient income – nor does it act as an “aggregate” of all fixed income sectors. Expanding beyond the Agg and/or dissecting the Agg's sectors to target specific risk and return characteristics can better position portfolios in our new, but familiar, income regime.
Exchange traded funds (ETFs) can be useful tools to gain different exposures — both within and beyond the Agg. To tailor your fixed income allocation to meet your risk tolerance and income objectives, you can:
1. Equal Weight the Agg's Sectors
The Agg's market-cap weighting scheme results in a heavy bias toward Treasuries (~40%), which tends to reduce the index's yield while extending its duration. By using subcomponents of the Agg to equal weight the Agg’s core bond sectors (investment-grade corporates/credit, mortgage-backed securities and Treasuries), you can seek a more balanced sector exposure with similar risk/return (duration/yield) profiles. This is the most basic way to improve upon the Agg, and its beauty is in its simplicity.
As shown in the chart below, this simple adjustment in sector weighting would result in a slightly higher yield at nearly the same duration, thereby improving the risk/return tradeoff while creating a more balanced subsector exposure.