Following extraordinary monetary policies that sent rates tumbling and stock prices higher, the yield of the standard 60/40 stock/bond portfolio is now 41% below its long-term average.1
With stocks yielding near their record low, bonds are needed more than ever to carry the coupon load for a portfolio. However, basic bonds yield only 1.27%.2 Therefore, generating more income requires you to take on more risk — either duration, credit or currency.
Unfortunately, the composition of the Bloomberg US Aggregate Index (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 today’s portfolios.
Given the nearly 500 strategies currently in market, exchange traded funds (ETFs) can be useful tools to gain different exposures — both within and beyond the Agg as well as with active and passive mandates. To tailor your fixed income allocation to meet your risk tolerance and income objectives, you can:
1. Seek to Optimize the Agg’s Yield per Unit of Duration
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. A basic solution to this would be to construct an equal weighted portfolio of the Agg’s subcomponent sectors (investment-grade corporates/credit, mortgage-backed securities and Treasuries). This results in a more balanced sector exposure with a similar risk/return (duration/yield) profile, along with an ever-so-slight improvement to the yield-per-unit of duration metric (0.27 versus 0.26 for the Agg).
Yet, this slight improvement doesn’t really solve the current conundrum in fixed income portfolio construction.
Optimizing the weighting of the subcomponents (maturity bands) of the core Agg sectors to maximize the yield per unit of duration can take an alternative weighted core Agg a step further — allowing 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 (a tactic that can be efficiently implemented with the range of transparent fixed income ETFs), you can adjust the balance between all segments to target the best possible exposure given portfolio constraints – such as the yield and duration tradeoff.
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 32% less duration but no sizeable reduction in yield, this allocation improves the risk/return tradeoff afforded by the Agg by 40% (0.36 versus 0.26 yield per unit of duration), while staying aligned to the heritage sector exposure and not noticeably increasing spread risk.
Optimized Core Agg Sector Weights and Constraints
Agg Sector Weight Cannot Exceed 40% or be less than 20%
Each Duration Bucket Weight must be between 3% and 30%
Portfolio Option Adjusted Spread Cannot Exceed the Agg by 20%
Optimized Portfolio Versus the Agg
2. Add Nontraditional Bond Sectors
If you find that the confines of mortgages, Treasuries and corporates are too narrow to meet your objectives without overconcentrating the portfolio in any one sector, ancillary bond segments can offer 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, and this greater diversification potentially reduces risk. Incorporating these bond segments could help boost a portfolio's risk/return profile.
The hypothetical example below allocates 30% of the core fixed income portfolio to nontraditional bond sectors while maintaining the 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 one complement exposure.
Following this rules-based approach leads to a portfolio with 124% higher yield per unit of duration than that of the Agg (0.58 versus 0.26) and increased diversification across geographies and sectors. It also avoids taking on significant spread risk, as the overall credit spread level is commensurate with investment-grade corporate bonds (100 versus 80 basis points).4 As for diversification, the Bloomberg Fixed Income Risk Model shows that this portfolio has a lower expected standard deviation than the broader Agg, 2.91% versus 3.86%, due to the more expansive portfolio containing less correlated markets that go beyond a simple mix of high-grade corporates and Treasuries.
Optimized Core-Plus Agg Sector Weights and Constraints
EM Local Debt
US High Yield
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 100 basis points
Yield more than the Agg
Optimized Agg-Plus Versus the Agg
3. Structure Allocations Based on Outcomes
Bonds’ role in a portfolio generally falls across three dimensions: Income, Diversification, and Stability. And, as mentioned, core bonds have an unattractive yield and duration profile, constraining returns and income. Therefore, the portfolios mentioned so far seek to maximize yield per unit of duration while keeping spread risk (credit risk and implicit equity biases) in control. However, rather than use this optimized approach, you could structure a portfolio to target the three goals of a bond portfolio in an equal manner.
To do this, assets must be selected for their properties related to those three attributes and placed into three individual buckets. Within each bucket, the strategies are then equal weighted to provide overall diversification where no one area dominates the portfolio – neither the buckets nor the underlying strategies.
The three buckets are defined as:
Diversification: Strategies with a negative correlation to stocks
Income: Markets with a high income potential
Stability: Exposures with low standard deviation of returns, likely short-term funds
The chart below shows the allocations to these three buckets and the ensuing results relative to the Agg. As shown, the three bucket portfolio has a yield above that of the Agg and a lower duration along with an option adjusted spread just slightly over 100 basis points. Additionally, the Bloomberg Fixed Income Risk Model shows that this portfolio has a lower expected standard deviation than the broader Agg, 3.72% versus 3.86%, due to its focus on diversity and stability in addition to income.
Three Bucket Portfolio Weights
EM Local Debt
Investment-Grade Floating Rate Notes
Three Bucket Portfolio Versus the Agg
4. Focus on Risk Parity High Income
The portfolios above seek income for a given level of risk, but in all cases the yield obtained is below inflationary expectations of 2.7% over the next five years.5
Generating a higher yield requires taking on more credit risk, potentially increasing the overall volatility of a portfolio as some high income segments have higher levels of risk. To navigate this challenge, you could focus solely on high income sectors but in a risk aware manner through an equal risk weighted approach (i.e., risk parity).
Risk parity focuses on balancing the risk contributions of assets in a portfolio, and when determining portfolio weights, it focuses both on an asset’s volatility and correlations. While you can construct this portfolio using a model that focuses on expected risk, I chose here to focus on historical volatility and correlations (with a 12-month lookback) for simplicity and transparency. And it’s worth noting that the marginal contribution of risk from an asset will change as the volatility profile of assets change. As a result, the weights below could change depending on the market environment.
For today’s market, applying a risk parity approach to high income sectors such as EM local debt, global short-term high yield, US short-term high yield and senior loans results in a portfolio with a yield of 4.4%, a duration of 2.11 years and a credit spread on par with a single fixed rate high yield exposure (308 versus 318), as shown below. The portfolio also features more sector diversity (and yield) than owning only high yield as an income producing sleeve. From a risk model perspective, standard deviation is actually below that of the Agg and a standalone high yield exposure (3.74% versus 3.86% and 4.16%), as some of these high income sectors are not that closely correlated, and less volatile segments do receive a higher weight.
Risk Parity High Income Weights
Short-term US High Yield
Short-term Global High Yield
EM Local Debt
Capital Efficent Risk Parity High Income Versus the Agg
5. Create a Capital Efficient Risk Parity High Income Core
This fifth portfolio expands on the risk parity high income idea, acknowledging that a pure high income portfolio would have a high level of implicit equity risk and therefore, not really offer total portfolio diversification to the equity side of an allocation. To try and maintain the intent of a high income portfolio but efficiently balance equity diversification, add long-term Treasuries.
Long-term Treasuries (20+ maturity) have a duration of 19.85 years.6 Given that the Agg has a duration of 6.8, a 34% allocation to long-term Treasuries would provide a broader portfolio with the same dollar duration as a 100% allocation to the Agg. Therefore, long-term Treasuries are a more capital efficient tool (i.e., you only need one-third of the portfolio to obtain the same duration profile as broad core bonds) for basic bond diversification.
Given that the high income risk parity portfolio has only two years of duration, a 30% and 70% split between long-term Treasuries and the risk parity high income sleeve provides a similar level of duration (7.3 versus 6.74) as a 100% Agg exposure, but with a strong yield improvement, as shown below. And as far as implicit equity risk, the historical three-year beta to the S&P 500 Index of a capital efficient risk parity high income portfolio drops to 0.21 from 0.38 for the sole risk parity allocation.7
Capital Efficient Risk Parity High Income Versus the Agg
Building Better Bond Portfolios with ETFs
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 to customize beyond what the Agg offers, fixed income ETFs, including actively managed solutions, can be effective building blocks for a tailored portfolio.
1 Based on the 60/40 allocation of the MSCI ACWI Index and the Bloomberg Global Aggregate Index the current yield today based on the dividend yield for the stocks and yield to worst for the bonds is 1.47%, per Bloomberg Finance L.P. as of 12/13/2021 compared to the 27 year average 2.7% based on calculations by SPDR Americas Research. 2 Based on the yield to worst on the Bloomberg Global Aggregate Index per Bloomberg Finance L.P. as of 12/13/2021 based on calculations by SPDR Americas Research. 3 S&P LSTA Leveraged Loan Total Return Index has a 0.08 correlation of monthly returns to the Agg. Bloomberg High Yield Index has a 0.22 correlation of monthly returns to the Agg. Bloomberg Emerging Market Local Currency Government Diversified Index has a 0.23 correlation of monthly returns to the Agg. Source: Bloomberg Finance L.P., 11/30/2016-11/30/2021. 4 Based on the option adjusted spread on the Bloomberg US Corporate Bond Index per Bloomberg Finance L.P. as of 12/13/2021. 5 Based on the US 5 year breakeven rate as of 12/14/2021 per Bloomberg Finance, L.P. 6 Based on the Bloomberg 20+ US Treasury Bond Index as of 12/14/2021 per Bloomberg Finance, L.P. 7 Based on the weighted average beta of the sectors to the S&P 500 Index from 12/2018 to 12/2021 per Bloomberg Finance, L.P.
Bloomberg 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 12/20/2021 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.
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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.
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