Learn To Love Indexing In Today's Bond Market

by: Louis Kokernak, CFA

Summary

The Aggregate Bond Index is the most popular benchmark for fixed income investors.

Only 40% of intermediate bond funds outperformed index funds over the past 10 years.

Open market operations of the world's central banks have changed the way bond indices are constructed.

Many Americans are familiar with popular stock market benchmarks like the Dow Jones Industrial Average or the S&P 500. The fixed income area is a less visible to the public. This article will discuss the characteristics of the Bloomberg Barclays Aggregate Bond Index and how indexed bond investing fits into an investment portfolio.

Why Indexed Bond Investing?

Passive investment is a viable option in the fixed income markets just as it is in equity markets, though its numerical superiority isn't quite as dominant. Morningstar issues an Active/passive Barometer twice a year to compare the performance of active managers against passive managers. The ten year results ended December 31st, 2015 reveal that only 39.7% active bond managers outperformed their indexed counterpart funds.

There is bad news even for those managers that do beat their benchmark. Vanguard's latest Persistence Scorecard reveals that top quartile bond managers are no more likely to remain in that position than random chance would allow.

Over the five-year measurement horizon, the results show a lack of persistence among nearly all the top-quartile fixed income categories.

I wouldn't argue that these two reports alone advocate for the exclusive use of indexed bond funds. However, the data does drive home two consistent themes: Most active managers lag not just their benchmarks but actual funds managed to a benchmark; Even those that outperform for extended periods do NOT continue to outperform. At minimum, history argues for a considerable allocation to passive bond investments.

History and Composition

The US Aggregate Bond Index was developed at the boutique investment bank of Kuhn, Loeb in the 1970s. The index gained broad acceptance in 1986 after Wall Street powerhouse Lehman Brothers acquired of the smaller firm. Barclays inherited the index business through its 2008 acquisition of Lehman during the subprime crisis.

It is generally considered to be one of the best recognized benchmarks in the American fixed income space. According to eVestment, about $663 billion of institutional assets is invested in 270 U.S. core fixed-income portfolios, 75% of which are benchmarked against the Barclays aggregate bond index.

This index itself is market value weighted. That is, the weight of each issue is roughly proportional to the amount issued by the public.

What is included? There are a lot of rules but they can be boiled down to an essential description: The aggregate bond index consists of all investment grade, taxable, fixed-coupon bonds. That excludes inflation-linked securities (OTC:TIPS), junk and municipal bonds. Smaller issues that trade infrequently are also excluded.

The Chart below provides the reader a sense of proportion as to the size of the included and excluded bond markets, Keep in mind that there is no definitive figure on the size of the junk bond market in the US.

Once these excluded categories are removed from the total bond market, the remaining assets look remarkably like the Bloomberg Barclays Aggregate Bond index. If you look quickly at the pie charts below, you will barely notice any difference.

The State of the US Bond Market

The aggregate bond index conveys important information to investors. By examining the properties of the entire bond market, we get a sense of its risks and returns in the financial markets. It's no secret that yield is hard to come by in today's public markets and it's borne out by the data.

The yield of the index recently stood at 2.04% on September 9th , one of its lowest measures since it was constituted 40 years ago. Interest rate risk, as measured by duration, is relatively high at 5.6 years. The 5.6 year duration means that a 1.0% change in interest rates would translate into a 5.6% change in price of the aggregate bond index. Thus, today's bond investors are assuming a historically high level of interest rate risk for a low expected return.

It's no surprise, then, many investors have stepped away from traditional high quality bond space to capture more yield. Investors have chased yield into lower quality credit spaces. Junk bonds, preferred stocks, and emerging market bonds have seen large inflows of cash since the great recession. It is appropriate to have some weighting to bond markets that lie outside conventional indexation.

That said, speculative grade and foreign currency bonds should not comprise the core holdings of most fixed income investors. The recent past has shown that such holdings can suffer large declines with the onset of recession. My recent article on Preferred Stocks helps to drive home that point.

A recent trend in today's fixed income markets is the aggressive purchasing of a wide swath of bond assets by the world's central banks. Since 2008, our own Federal Reserve has accumulated over $4.5 trillion of Treasury, Agency, and mortgage-backed bonds. These are not readily tradable in the open market. Consequently, Barclays developed a float-adjusted bond index that excludes issues held by central banks and other insider parties.

Bottom line, there is no fundamental difference between the Market weighted and Float adjusted total bond index - though there are fewer mortgage-backed securities in new index. Why discuss such details? The largest total bond index fund in world, Vanguard, started using the floated adjusted index in late 2009 to reflect the aggressive open market purchases of the Federal Reserve. Vanguard felt it was implementing best indexing practices. At this point, retail investors need not distinguish between the two as both have similar yields, credit distribution, and interest rate risk.

How to Invest

Investment grade bonds in the US still offer expected returns capable of keeping pace with inflation. That's a low bar but, frankly, superior to what other major developed bonds offer. Retail investors have numerous mutual fund and exchange traded funds options to buy the aggregate bond index. Here are some key examples:

Supporting Documents

  1. persistence-scorecard-august-2016.pdf
  2. Active-Passive_Barometer_from_Morningstar__04-16.p...

Disclosure: I am/we are long VBTLX, AGG, SCHZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.