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.
These slight modifications reduce concentration, but you can use the same basic building blocks to further tailor portfolios. Focusing on just the intermediate part of the Agg's subsectors can lead to an even more beneficial yield and duration profile. The sector allocation shown above is also shown in the figure below, but in the figure below, we are using just the intermediate portion of the Treasury and corporate/credit market. In this example, the yield still remains close to that of the Agg, but the duration is significantly reduced, dropping from 6.1 to 3.6 years. The yield per unit of duration of this portfolio is 0.30, versus just 0.21 for the Agg.
Intermediate Corporate Credit
The lack of material yield differences are a result of the current environment, in which a historically flat yield curve — even though it has steepened as of late — has compressed the spread between different tenors, essentially leading to similar yield figures for a 1–10-year exposure and a 10+ but with markedly different durations. For instance, 1–10-year corporates yield 1.6%, while 10+ corporates yield 3.2%, but the duration is 11 years shorter in the 1–10 year space. In this very basic example, the sector diversification is achieved while also improving the yield/duration (risk/return) profile (0.3 versus 0.21). And this intermediate-centric allocation, with its more optimal yield/duration, may mitigate any further steepening of the curve as a result of the increased issuance of Treasuries to fund the massive fiscal stimulus plans – either those already in place or ones yet to be announced.
2. Seek to Optimize Yield per Unit of Duration
You can take assigning equal weights to the Agg's sectors’ alternative weighting a step further. By optimizing the weighting of core Agg sectors to maximize the yield per unit of duration, you can impose risk constraints to keep the exposure within your risk tolerance.
This bespoke approach can allow you to meet your objectives with more precision while staying within the traditional exposures of the Agg. By using targeted exposures to delineate between short-, intermediate- and long-duration exposures within the corporate and Treasury sleeves, you can adjust the balance between the three to target the best possible exposure given portfolio constraints.
The figures below illustrate how the Agg sector weights are adjusted to optimize yield per unit of duration while still complying with risk constraints. With 35% less duration but no reduction in yield, this allocation improves the risk/return tradeoff afforded by the Agg by 54% (0.33 versus 0.21 yield per unit of duration), while staying aligned to its heritage sector exposure does not increase spread risk.
Agg sector weight cannot exceed 40% or be less than 20%
Each duration bucket weight must be between 3–30%
Similar yield but with a portfolio, option-adjusted spread cannot exceed the Agg by 20%
3. Add Nontraditional Bond Sectors
You may find that the confines of mortgages, Treasuries and corporates are just too narrow to meet your objectives without overconcentrating the portfolio in any one sector. In these types of situations, ancillary bond segments can provide potential diversification and income benefits.
Bond segments like senior loans, high yield and emerging market debt are historically less correlated with the Agg.3 When assets are less correlated with one another, their prices tend to diverge, offering the potential for greater diversification and thus, reduced risk. Incorporating these bond segments can help boost a portfolio's risk/return profile.
The hypothetical example below allocates 30% of the core fixed income portfolio to complements while maintaining a 70% weighting to the optimized Agg exposure shown in the previous example. As illustrated, this would result in an improved yield/duration profile, one without overconcentration in any singular complement exposure.
Following a rules-based approach like this leads to a portfolio with 200% higher yield per unit of duration than that of the Agg (0.64 versus 0.21) and increased diversification across geographies and sectors. This also avoids taking on significant spread risk, as the overall credit spread level is commensurate with investment-grade corporate bonds (150 basis points). As for diversification, the Bloomberg Fixed Income risk model shows that this portfolio has a lower expected standard deviation than the broader Agg, 4.75% versus 5.13%, due to the more expansive portfolio containing less correlated markets that go beyond a simple mix of high-grade corporates and Treasuries.
US High Yield
IG International Corporates
IG Floating Rate Notes
Pan-European High Yield
70% in optimized Agg
No more than 10% in one of the non-Agg sectors
No less than 2% in one of the non-Agg sectors
Credit spread less than 150 (spread of IG Corporates)
Yield more than the Agg
4. Focus on Risk Control
Many of the portfolios mentioned so far seek to maximize yield per unit of duration while keeping spread risk in control. Another way to structure a portfolio that seeks to balance risks would be to bifurcate it by the risks inherent in the allocations by looking at the drivers of each exposure’s risk.
Including international bonds in the above expanded portfolio introduces currency risk alongside duration and credit. Emerging market local debt returns have an over 91% correlation with movements in emerging market currencies,4 and risk modelling shows that currency risks represent 70% of its risk profile.5 Meanwhile, duration risk can manifest itself in two ways – Treasuries and portions of the investment-grade credit market. The latter, while a credit tool, will have returns impacted by changes in the yield curve in addition to changes in credit spreads. The same goes for mortgage-backed securities. However, combining that with more growth-oriented credit creates another risk bucket: credit/growth.
Modeling the drivers of risk, therefore, allows for specific portfolio construction techniques to properly balance each risk across Currency, Rates, Credit/Growth. The latter is more titled toward the growth portion, given some rate sensitivity of IG credit. The figure below illustrates an allocation where short-duration high yield was chosen over broad high yield given the elevated spread risk and given the lower-rate - essentially zero – rate risk.
Developed Ex-US IG Corp
Developed Ex-US Sovereigns
EM Local Debt
Short-Duration High Yield
In each risk bucket, the assets are equally weighted, resulting in the profile shown below, from a yield, duration, and spread perspective. The risk profile is also balanced, with 23% from yield curve, 23% from currency, and 54% from credit spread risks.
5. Create a Tax-Aware Exposure Similar to the Agg
For more tax-aware portfolios, you could use short-term, high yield and traditional municipal bond sector exposures to match the yield/duration tradeoff provided by the Agg, while staying within the confines of tax-beneficial municipal bonds.
The figure below illustrates a 40% allocation to traditional municipal bonds, 45% to short-term municipal bonds and 15% to high yield municipal bonds. This results in a portfolio with a nearly identical yield and duration profile to that of the Agg, with only slightly higher spread risk but comprised of only municipal bonds for the tax-conscious investor.
While indexing to the Agg can provide an off-the-shelf solution for broad fixed income exposure, investor risk constraints, return objectives and tax considerations can vary significantly. When looking for customization beyond what the Agg can offer, some bond ETFs, including actively managed solutions, can be building blocks for a tailored portfolio.
1 Based on the 60/40 allocation of the MSCI ACWI IMI and the Bloomberg Barclays Global Aggregate Index the current yield today based on the dividend yield for the stocks and yield to worst for the bonds is 1.8%, per Bloomberg Finance L.P. as of 06/25/2020 based on calculations by SPDR Americas Research.
2 Based on dividend yield of the MSCI ACWI IMI and the yield to worst on the Bloomberg Barclays Global Aggregate Index per Bloomberg Finance L.P. as of 06/25/2020 based on calculations by SPDR Americas Research.
3 S&P LSTA Leveraged Loan 100 Total Return Index has a 0.08 correlation of monthly returns to the Agg. Bloomberg Barclays High Yield Very Liquid Index has a 0.17 correlation of monthly returns to the Agg. Bloomberg Barclays Emerging Market Local Currency Government Diversified Index has a 0.27 correlation of monthly returns to the Agg. Source: Bloomberg Finance L.P., 05/30/2015-05/30/2020.
4 Bloomberg Barclays Emerging Market Local Currency Government Diversified Index versus MSCI EM Currency Index based on monthly returns Bloomberg Finance L.P., 05/30/2015-05/30/2020.
5 Based on the Bloomberg Fixed Income Risk Model for the Bloomberg Barclays Emerging Market Local Currency Government Diversified Index as of 06/24/2020.
Bloomberg Barclays US Aggregate Bond Index (the Agg)
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US-traded investment-grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury, government agency bonds, mortgage-backed bonds, corporate bonds and a small amount of foreign bonds traded in the US.
The difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality.
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
The views expressed in this material are the views of Matthew Bartolini through the period ended 6/25/2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
Past performance is not a reliable indicator of future performance.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA, AL’s express written consent.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
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