Getting More from Your Core Bonds | Lord Abbett
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Market View

The composition of the Bloomberg U.S. Aggregate Bond Index is increasingly dominated by U.S. government debt. Here’s why investors may wish to look outside the index for more attractive yield.

Read time: 5 minutes

Time marches on, and people tend to look markedly different as the years pass. That can also be the case with investment benchmarks. Witness the change in composition over time of the widely followed Bloomberg U.S. Aggregate Bond Index (formerly the Bloomberg Barclays U.S. Aggregate Bond Index), popularly known as the “Agg.” We looked at this phenomenon in a Market View earlier this year; given the market activity since then, we thought this would be a good time to revisit the topic, this time exploring the implications for investors in core fixed-income strategies.

As a reminder, the Bloomberg Aggregate’s investment universe consists of all U.S. investment-grade, fixed-rate bonds, with index components for government and corporate securities, mortgage pass-throughs, and asset-backed securities. Figure 1 shows that since the 2008–09 global financial crisis (GFC), the most significant change in the composition of the index has been a large increase in the weighting of U.S. Treasury securities. This change reflects the enormous amount of debt issued by the U.S. government to help lift the nation’s economy out of a recession following the GFC, along with another wave of Treasury issuance to counter the effects of the COVID-19-driven market pullback in March 2020.

 

Figure 1. The Composition of the “Agg” Has Changed Greatly Over the Years
Composition of the Bloomberg U.S. Aggregate Bond Index, based on market value

Source: Bloomberg. Data as of August 31, 2021.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Given these compositional changes, investors should be mindful of the characteristics of passive strategies that track the Aggregate index such as the popular iShares Core U.S. Aggregate Bond ETF (AGG). As seen in Figure 2, over the past decade or so, the yield of the Aggregate Index has declined by about 80% to near all-time lows, while the duration has increased by about 50% to near all-time highs. Over time, the “Agg” and portfolios that track the index have been increasingly dominated by government debt, increasing interest-rate risk while offering less and less yield.

 

Figure 2. Core Bond Yields Have Declined as Duration Has Extended
Duration and yield of the Bloomberg U.S. Aggregate Bond Index, September 30, 1991–September 14, 2021

Source: Bloomberg Index Services Limited. Data (monthly) as of September 14, 2021.
Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

We do not have to look far to see an example of how unattractive bond math can lead to yield erosion rather quickly. The first quarter of this year provides a good example: from December 31, 2020 to March 31, 2021, the 10-year U.S. Treasury yield rose 81 basis points over the year-earlier period, leading to a     -3.37% price drop for the Bloomberg Aggregate.

While rates have rallied since March 31 of this year, the index is still down -0.34% year-to-date through September 14, as the low current income has not been enough to offset the price drop triggered by higher rates. Going forward, a 6.65-year duration and 1.42% yield does not leave much margin for error for another uptick in rates.

Considering “Core Plus”

After a long period of stubbornly low interest rates, interest-rate volatility in 2021 may prompt investors to re-examine the role of their fixed-income allocations. Against such a backdrop, investors may wish to evaluate their current core allocations to ensure the strategies are likely to serve the volatility-dampening role they expect.

One option is to look for a “Core Plus” approach that offers yield opportunities and a differentiated risk profile from the Aggregate Index and the more conventional “Core” options that often closely mirror the popular index. Core Plus options also may allow investors to reduce the interest-rate sensitivity in their bond portfolios, relative to the Aggregate Index, by adding credit to offset duration exposure.

Understanding the Benchmark

To understand the opportunity for differentiation within intermediate-term bond investing, it is essential to understand what is included and excluded from common investing benchmarks. Among Core Plus strategies there are ample opportunities for an active, flexible, bottom-up manager to add value—both from a security selection and off-benchmark, sector allocation standpoint.

The core bond universe is massive—approximately $51.0 trillion as of March 31, 2021, according to Securities Industry and Financial Markets Association (SIFMA)—and includes a wide range of securities. However, the widely used Agg represented roughly half of that amount ($26.3 trillion) as of March 31, 2021.

The Aggregate Index follows specific rules and limitations meant to control inclusion and to conduct rebalancing in a specific manner. Additionally, each individual security eligible for inclusion must adhere to specific liquidity constraints based on each sector. Figure 3 shows the size of the Agg categories and the potential opportunities outside of the benchmark.

 

Figure 3. Looking Beyond the “Agg” for Yield Opportunity
Market value of broader core bond universe (based on SIFMA data) versus Bloomberg U.S. Aggregate Bond Index, by component, as of August 31, 2021 

Source: Securities Industry and Financial Markets Association (SIFMA). Data as of August 31, 2021 and are approximate based on available data.
Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Core Plus active managers have been able to take advantage of security selection by investing non-benchmark issues in the investment-grade universe, as well as sector allocation through “off-benchmark,” high yield and floating-rate allocations. The ability of Core Plus managers to use “off-benchmark” security selection and sector allocations has helped them realize higher returns than the “Agg” and its Core Bond counterparts (based on Morningstar category data) over the year-to-date, one-year, three-year, and five-year periods through September 7, 2021 (see Figure 4).

 

Figure 4. How Has Core Plus Stacked Up Versus the Agg and Core Bonds?
Returns by Morningstar category for the indicated periods through September 7, 2021

Source: Morningstar. Data as of September 7, 2021. Per Morningstar definitions, intermediate-term core bond portfolios invest primarily in investment-grade, U.S. fixed-income issues including government, corporate, and securitized debt, and hold less than 5% in below-investment-grade exposures; intermediate-term core-plus bond portfolios invest primarily in investment-grade, U.S. fixed-income issues including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging-markets debt, and non-U.S. currency exposures. Durations (a measure of interest-rate sensitivity) for the Core and Core Plus categories typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.

 

Potential Benefits of a Core Plus Approach

Considering the factors noted above, we believe a flexible, multi-sector approach to an intermediate-term U.S. bond allocation may potentially provide an attractive alternative for fixed-income investors. Such an approach could offer broad diversification across sectors, with the flexibility to adjust allocations to adapt to the market environment as conditions change.

This creates a greater opportunity for enhanced yield and total return potential, in our view. For a current example, the environment for credit could support additional spread tightening within the framework of a U.S. economic recovery. With a scenario of continued improvement in the U.S. economy, rates may begin to normalize from their current levels and put upward pressure on negative real rates. In our view, a Core Plus option may provide a higher yield and a greater potential for spread compression, which can offset higher rates.

All in all, given the changed composition of the “Agg,” historically low yields, and duration near multi-decade highs, we think a flexible multi-sector, Core Plus approach may hold increasing appeal for long-term investors.

 

 

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A basis point is one one-hundredth of a percentage point.

 

Core bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt. Core plus is an investment management style that permits managers to add instruments with greater risk and greater potential return to a core bond strategy.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Exchange-Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

real interest rate is the rate of interest excluding the effect of expected inflation.

Yield to maturity is the rate of return anticipated on a bond if held until it matures.

The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The Bloomberg U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

Bloomberg Index Information


Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.  

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