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Five Ways to Customize Your Fixed Income Core

With yield of the standard 60/40 stock/bond portfolio at the lowest levels on record, portfolio construction of the fixed income core has likely never been more important than it is today.

Head of SPDR Americas Research

Following extraordinary monetary policies that sent rates tumbling and surging equity markets that have sent stock prices higher, the yield of the standard 60/40 stock and bond portfolio is now 36% below its long-term average.1

With stocks yielding their least amount on record, bonds are needed more than ever to carry the coupon load for a portfolio. However, basic bonds only yield 1.11%. Therefore, generating more income requires investors to take on more fixed income risk — either duration, credit or currency.

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.

Treasury

33.3%

Corporate Credit

33.3%

Mortgages

33.3%

Equal Weighted Agg vs. The Agg

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 6.46 to 4.17 years. The yield per unit of duration of this portfolio is 0.288, versus just 0.22 for the Agg.

Intermediate Treasury

33.3%

Intermediate Corporate Credit

33.3%

Mortgages

33.3%

Equal Intermediate Weighted Agg vs. the Agg

The lack of material yield differences is a result of the current low rate environment that has created asymmetrical yield/duration profiles the further the maturity is pushed out. For instance, 1–10-year corporates yield 1.35%, while 10+ corporates yield 3.16%, 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 (0.28 versus 0.22). 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 future ones.

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 25% less duration but no sizeable reduction in yield, this allocation improves the risk/return tradeoff afforded by the Agg by 26% (0.28 versus 0.22 yield per unit of duration), while staying aligned to its heritage sector exposure does not increase spread risk.

Portfolio Weights

Treasuries

Short Term

14.0%

 

Intermediate

3.0%

 

Long Term

3.0%

     

Corporates

Short Term

4.6%

 

Intermediate

30.0%

 

Long Term

5.4%

     

Mortgages

 

40%

     

Constraints

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%
 

Optimized Portfolio vs. The Agg

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. 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 82% higher yield per unit of duration than that of the Agg (0.41 versus 0.22) 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 (80 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, 2.64% versus 3.56%, due to the more expansive portfolio containing less correlated markets that go beyond a simple mix of high-grade corporates and Treasuries.

Portfolio Weights

Treasuries

Short Term

10%

 

Intermediate

2%

 

Long Term

2%

Corporates

Short Term

3%

 

Intermediate

21%

 

Long Term

4%

Mortgages

 

28%

Non-Agg

EM Debt

2.0%

 

US High Yield

2.6%

 

IG International Corporates

3.4%

 

Senior Loans

10.0%

 

IG Floating Rate Notes

10.0%

 

Pan-European High Yield

2.0%

Portfolio Constraints

 

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 80 (spread of IG Corporates)

 
Yield more than the Agg

Optimized Agg-Plus versus 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 90% correlation with movements in emerging market currencies, and risk modelling shows that currency risks represent 70% of its risk profile. 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.

Weight

Risk

 

 

 

32.5%

Currency

Developed Ex-US IG Corp

Developed Ex-US Sovereigns

 EM Local Debt

32.5%

Defensive Rates

Treasuries

TIPS

 

15.0%

Credit/Growth

Mortgage-Backed Securities

IG Corporates

 

20.0%

Short-Duration High Yield

Bank Loans

Convertibles

Risk Controlled Portfolio versus the Agg

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 24% from yield curve, 34% from currency, and 42% 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, 30% to short-term municipal bonds and 30% to high yield municipal bonds. This results in a lower duration portfolio with a nearly identical yield profile to that of the Agg, with only slightly higher spread risk but comprised of only municipal bonds for the tax-conscious investor.

Short Term

40%

Intermediate

30%

High Yield

30%

Comparing Risk/Return Profiles: A Bond Portfolio for the Tax Aware 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.

Check out the SPDR® ETF product list to view our fixed income ETFs. And our quarterly SPDR Fixed Income Dashboard can help you analyze the current fixed income marketplace.

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