That Bond Fund You Probably Own? Let’s Kick the Tires Again
Retirees, and those soon to retire, need to know about rising risks in a favored bond index
Managing your investment portfolio is a lot like being the head coach responsible for fielding a winning team. For scoring power, you turn to stocks, which over the long term have delivered the best inflation-beating gains. But you know defense is what wins championships, and for protection you own bonds.
Lately bonds have been doing double duty. Through mid-October, the Bloomberg Barclays US Aggregate bond index is up nearly 8% in 2019. What the S&P 500 index is to stocks, “the Agg” is to bonds. It’s considered the market benchmark for high-quality bonds. If you own a bond fund with the term “core” in it, you’re an Aggregate investor. Mutual funds that track the Aggregate are the most common bond offering in retirement plans.
As good as performance has been lately, there are some quirks in the composition of the Aggregate index that could cause headaches in the future. To be clear, there is nothing ominously dangerous with the Aggregate. If you stick with a fund or exchange-traded fund that tracks the Aggregate, you will likely do just fine over the long term. When a stock bear market hits, an Aggregate-tracking fund or ETF is going to provide defense.
But it may not be the best way to play defense. To understand why requires taking a tour inside what the Aggregate owns, and a short review of how changing interest rates impact bond performance.
The Aggregate index tracks high-quality U.S. bonds. That includes Treasuries, mortgage-backed securities and corporate bonds. So-called “junk” bonds issued by borrowers on shakier financial footing aren’t allowed in the index. That’s exactly what you want for your defense.
But there are other characteristics of the Aggregate index that will likely cause a fund that tracks this index to be a little weaker in the amount of defense it provides in different market conditions.
Right now you’re likely well aware that interest rates are very low. While that’s been frustrating for investors who want to earn interest on their bonds, it’s been a godsend for institutions issuing bonds. Their cost of borrowing is super-low, and companies can lock in those low interest costs by issuing bonds that last up to 30 years.
This is where it’s useful to understand a key bond fund metric, called duration. The performance of your fund or ETF is very dependent on what happens to interest rates. Duration — expressed as years —tells us how sensitive a bond fund or ETF will be when interest rates change. The longer the duration the more interest rate risk you are taking.
The Aggregate index currently has a duration of about six years. (Before the financial crisis its duration was under five years.) That means that if interest rates were to fall 1 percentage point, the price of the bonds in the Aggregate index would rise about 6%. That’s why core bond funds have done so well in 2019 — interest rates have had a big drop.
But remember, you own bonds for defense. And that six-year duration means that if we saw interest rates rise 1 percentage point in 12 months, the price of the bonds in the index would fall around 6%. If rates rose 2 percentage points, the bond prices would fall around 12%.
The total return you earn for a fund or ETF is the sum of what’s happened to the prices of bonds it owns, and the interest (yield) that the fund’s bonds paid. When prices are falling, the yield provides some cushion. But today’s starting yields are so low — the index has a current yield of around 2.3% — they’re not going to offset price declines.
If rates rise 1 percentage point, the price of an Aggregate fund would drop around 6%, and even though the yield cushion increases to 3.3%, that’s still going to leave you with a negative return. Indeed, from September 2017 into May 2018, as interest rates were rising, an ETF that tracks the Agg had a total return of negative 3%.
Another issue is the types of bonds in the Aggregate. The size of the investment-grade corporate bond market has more than doubled since 2008. While all of these bonds are high quality, there is a lot of variation in terms of how high.
Some corporations are in great financial shape. They are rated AAA, AA or A. On the final rung of investment grade are BBB-rated bonds. These are the financially weakest of the quality corporate bonds. If their fortunes sour — due to pressure in a recession, a new competitor, poor management decisions — their financial-strength rating could be reduced, and that means they would fall into the “junk” category. Before the financial crisis, about 36% of investment-grade corporate U.S. bonds were rated BBB. Today we’re at 50%. That raises the potential for a rockier ride in a recession. Some of those BBBs are drawing concern.
If any of that gives you pause, you might consider broadening your bond portfolio to include more than just an Aggregate-tracking fund. The best, purest, defense when stocks falter are U.S. Treasuries. The Agg index has about 45% invested in Treasuries. Late in 2018 (Oct. 3 to Dec. 24) when stocks fell nearly 20%, the iShares Core U.S. Aggregate Index ETF gained 1.7%. Even better was the 2.7% gain for the Vanguard Intermediate-Term U.S. Treasury ETF. By comparison, the Vanguard Intermediate Term Corporate bond ETF barely broke even.
If you want to reduce your portfolio’s risk of being scuffed up when rates rise, you might also want to weave in shorter-term bond funds or ETFs into your strategy. There are plenty of low-cost index funds and ETFs that focus on high-quality bonds with a duration of three years or less. And to tie it all together, there are Treasury-only funds and ETFs that have durations much shorter than the nearly six years for Aggregate-tracking funds.