2 ETFs To Enhance Total Bond Market Yield

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Includes: BND, BOND, TOTL
by: Matthew Sauer, Esq.

Summary

After 2008, the U.S. Treasury increased its borrowing and shifted to shorter maturities.

After 2008, private sector borrowers deleveraged or slowed their borrowing.

Since they represent the total market, passive total bond market indexes increased their exposure to short-term U.S. Treasuries, reducing portfolio yield.

AGGY and SHAG offer investors similar total bond market exposure, but with enhanced yield.

In July 2015, WisdomTree launched the Barclays Yield Enhanced U.S. Aggregate Bond Fund (NYSEARCA:AGGY), an ETF designed to enhance the yield of the index behind the largest total bond ETF, the $45 billion iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG). Thus far, it is a success. AGG has a 30-day SEC yield of 2.23 percent and AGGY has a yield of 2.80 percent. Since inception through June 21, AGGY has a total return of 7.62 percent. Over the same period, AGG gained 5.91 percent.

AGG tracks the Bloomberg Barclays U.S. Aggregate Bond Index. AGGY tracks the Bloomberg Barclays U.S. Aggregate Enhanced Yield Index, what is describes as a "rules-based approach re-weights the subcomponents of the Bloomberg Barclays U.S. Aggregate Bond Index to enhance yield, while broadly maintaining familiar risk characteristics."

The case for AGGY is straightforward. The total bond index must invest as the market dictates and it is a reflection of borrower behavior, not investors. The credit markets have shifted considerably in the past decade as public and private borrowing changed. Since 2008, the government was willing to borrow while private enterprises and consumers deleveraged. As a result, Treasuries became a larger percentage of the total bond market and total bond funds such as AGG increased Treasury exposure. Since the government was mainly issuing short-term bonds, this subsequently reduced the yield on passive total market bond funds.

AGG currently has 33 percent in Treasuries, 23 percent in corporate bonds and 18 percent in securitized bonds. AGG had 72 percent of assets in AAA bonds at the end of 2016.

AGGY's index deviates from AGG's weightings and moves into higher yielding corporate securities. It holds 16 percent in Treasuries, 47 percent in corporate bonds and 32 percent in securitized bonds. It had 51 percent in AAA securities at the end of 2016.

There are some limits on how far AGGY can deviate from the index. AGGY's duration cannot be more than one year longer than the index. The weights of the various subcategories in AGGY will not deviate more than 20 percent from similar subcategories contained in AGG. To stay within these boundaries, AGGY is rebalanced by a maximum of 5 percent each month. The turnover percentage will step up by 1 percent (if necessary) until the correct weightings are achieved.

In sum, investors take on a little more credit and interest rate risk with AGGY and are rewarded with higher yield and better returns as long as credit risk isn't rising. AGGY has a slightly higher duration of 6.9 years versus AGG's 5.7 years.

Performance

Here's a chart of the relative performance of AGGY versus AGG. No surprise given the portfolios, AGGY underperformed when Treasuries outperformed from 2015 to early 2016, and then outperformed along with corporate bonds.

Here's a look at the performance of AGGY, AGG and three other bond ETFs covering the entire market: Pimco Active Bond (NYSEARCA:BOND), Vanguard Total Bond Market (NASDAQ:BND), SPDR DoubleLine Total Return (NYSEARCA:TOTL). The performance is shown relative to AGG.

AGG is cheaper than AGGY. It has an expense ratio of 0.05 percent, including a 0.01 percent fee waiver that expires in June 2021. AGGY charges 0.12 percent, including a 0.08 percent waiver through December 31, 2017. The higher fee has been more than made up for with superior performance.

SHAG

For investors worried about rising interest rates, WisdomTree has a new offering-the WisdomTree Barclays Yield Enhanced U.S. Short-Term Aggregate Bond Fund (BATS:SHAG). It implements the same basic strategy as AGGY, but targets the short-end of the bond market (1 to 5 years). SHAG has a duration of 3.0 years and a 30-day SEC yield of 1.84 percent.

The portfolio constraints on SHAG are slightly different from AGGY. The duration can only vary by 0.5 years. Major sector weightings can deviate by 30 percent, minor sectors by 15 percent, Baa credit by 30 percent. As with AGGY, the portfolio turnover can be as much as 5 percent per month, rising by 1 percent per month as needed.

SHAG has 18 percent of assets in government bonds, 70 percent in corporate bonds and 11 percent in securitized bonds.

SHAG has the same 0.12 expense ratio as AGGY, but its 0.08 fee waiver ends on December 31, 2018.

Conclusion

AGG 2017 is not the same fund as AGG 2007. While AGGY is slightly riskier than AGG today, the AGG of 2007 was also riskier than the AGG of 2017. AGG's U.S. Treasury weighting is about 10 percentage points higher than it was prior to 2008, and those bonds have shorter maturities and lower yield. Even ignoring the low rate environment, the shift in AGG's portfolio mix would have lowered income over the past decade relative to the older mix.

Investors who want a higher yielding portfolio, but who also want total bond market exposure, have two solid options from WisdomTree in AGGY and SHAG. The funds are designed to add more yield without greatly increasing the risk to the portfolio. It has been a successful strategy so far.

The main downside to these funds is their presently low volume. AGGY has an average daily volume of 25,000 and the market price was 0 to 24.9 basis points above net asset value for 60 days in the first quarter, or nearly 97 percent of the trading days. SHAG launched on May 18 of this year and has very low volume. Only 109 shares traded on Monday June 19, and 0 shares on June 20. AGGY's volume has been rising over time, but it still has days where it trades less than 10,000 shares.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.