Insights


Four Ways to Customize Your Fixed Income Core

When building a core fixed income allocation, many investors look to track the Bloomberg Barclays US Aggregate Bond Index (Agg). While this traditional exposure strategy is a simple way to gain broad bond exposure, the tradeoff for this simplicity has been a historically low yield and elevated interest rate risk.


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For some investors, the Agg may only be a good starting point that allows them to use complementary exposures to fine tune a fixed income portfolio. Others might look to dissect the Agg's sectors to more finely target specific portfolio risk and return characteristics.

For investors seeking more customization, 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 tend to reduce the index's yield while extending its duration. By using subcomponents of the Agg to equal weight the core bond sectors that comprise the Agg (investment grade corporates/credit, mortgage-backed securities and Treasuries), investors can seek a more balanced sector exposure with similar risk/return (duration/yield) profiles.

As shown in the figure below, this simple adjustment in sector weighting would result in a slightly higher yield at nearly the same duration, thereby slightly improving the risk/return tradeoff while creating a more balanced subsector exposure.

While these are slight modifications to reduce concentration, there is potential for more tailoring. Focusing on just the intermediate part of the Agg's subsectors can lead to an even more beneficial yield and duration profile. The same allocation by sector as above is shown in the figure below, but this time using just the intermediate portion of the Treasury and corporate/credit market. In this example, the yield still remains close to the Agg, but the duration is significantly reduced, dropping from 6 to 3.6 years. The yield per unit of duration of this portfolio is 0.59, versus just 0.38 for the Agg.

The pronounced differences are a result of the current environment, in which a flattening yield curve has compressed the spread between different tenors, essentially leading to similar yield figures for a 1-10 year exposure as 10+ but with markedly different duration. For instance, 1-10 year corporates yield 2.4% while 10+ corporates yield 3.5%, but the duration is 10.3 years less on the 1-10 year space. In this very basic example, the sector diversification is achieved while also improving the yield/duration (risk/return) profile.

2. Seek to Optimize Yield per Unit of Duration

Rather than assigning equal weights to the Agg's sectors, you can take 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 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 this process. In this example, the Agg sector weights are adjusted to optimize yield per unit of duration, while still complying with risk constraints. This results in an allocation with 43% less duration but only a one basis point reduction in yield, improving the risk/return tradeoff afforded by the Agg by 75% while staying aligned to its heritage sector exposure with less spread risk.

3. Add in 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 to the Agg.1 When assets are less correlated with each other, their prices tend to diverge, offering the potential for greater diversification and thus, reduced risk. As such, incorporating these bond segments can potentially 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, without overconcentration in any singular complement exposure.

Following a rules-based approach like this leads to a portfolio with 157% higher yield per unit of duration than the Agg and increased diversification across geographies and sectors, all while not taking on significant spread risk, as the overall credit spread level is commensurate to investment grade corporate bonds. And as for diversification, the Bloomberg Fixed Income risk model shows that this portfolio has a lower expected standard deviation than the broader Agg-1.4%, versus 3.1%-all due to the balanced nature of credit and interest rate risks within this more expansive portfolio that goes beyond a simple mix of high-grade corporates and Treasuries.

4. Get 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 an example of this approach, where an investor allocated 25% to traditional municipal bonds, 40% to short-term municipal bonds and 35% to high yield municipal bonds. The result of this strategy is a portfolio with a nearly identical yield and duration profile to 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.

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.

Footnotes

1 S&P LSTA Leveraged Loan 100 Total Return Index has a -0.14 correlation of monthly returns to the Agg. Bloomberg Barclays High Yield Very Liquid Index has a 0.11 correlation of monthly returns to the Agg. Bloomberg Barclays Emerging Market Local Currency Government Diviersified Index has a 0.27 correlation of monthly returns to the Agg. Source: Morningstar, 09/30/2014-09/30/2019.

Glossary

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.

Credit Spreads

The difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality.

Yield

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.