In a portfolio context, lower volatility
and potentially more predictable income streams can make fixed income investments attractive complements to equities. Additionally, the general downward trend that we’ve seen in interest rates
has helped make fixed income attractive from a total return perspective. One of the most recognized benchmarks for fixed income is the Barclays U.S. Aggregate Bond Index (Agg)
; however, investors have been looking outside the Agg in search of higher return potential.
Agg Does Not Rebalance Back to Constant Weights
Over time, the composition of the Agg has not been held constant, and as the patterns of issuance and eligibility in its different underlying sectors have changed, so have their weights within the Index. Today’s Agg looks much different than it did when it was created in 1986.1
Agg’s Sector Exposures as of September 30, 2015:2
• Government-related securities: 8.6%
• Corporate: 24.0%
What this tells us at a high level is that the Index may be very well positioned for any “risk-off
” environment with such a large weight in Treasuries. On the other hand, it is important to note that more than 22% of that 36.5% is in U.S. Treasuries maturing in five years or less, so if the U.S. Federal Reserve (Fed)
does in fact raise interest rates at some point in the near future, this part of the Treasury curve
may have a greater potential to feel the impact than the longer-maturity components.
What about a “Low & Slow” Fed and Improving Economic Conditions in the United States?
However, if the baseline view to be expressed is not one of an imminent risk-off change in sentiment, but rather a continued gradual improvement in U.S. economic conditions, is positioning with nearly 40% exposure to Treasuries the best option? We don’t think so, especially with the changing risk
profile of the Treasuries themselves.
What Is the Risk in U.S. Treasuries in the Current Environment?
Risk, in this context, is not meant as an outright default, as we don’t see the safe-haven status of U.S. Treasuries changing anytime soon. However, the experience of investing in bonds can be quantified by two important concepts:
• Yield to maturity
: At the time of purchase, this statistic encapsulates a measure of the returns to expect, assuming that all future coupon
and principal obligations are met.
: This statistic encapsulates how responsive the price of a bond might be, given a change in interest rates, with higher numbers indicating the potential for greater responsiveness.
The Bottom Line:
When looking at the yield-to-maturity/duration ratio
over time, an upward-sloping line indicates more potential compensation per unit of interest rate risk, while a downward-sloping line indicates less potential compensation per unit of interest rate risk.
Agg: More Exposure to U.S. Treasuries as Their Risk Profile Worsens
• The reality of the Agg, going back over a period of 13 years, is that today the Treasury component is close to its highest level over this period, while the yield-to-maturity/duration ratio is close to its lowest point. Additionally, it is clear that weight to Treasuries tended to increase at the same time the risk/reward trade-off for that exposure worsened.
Introducing the Barclays U.S. Aggregate Enhanced Yield Index
To address this issue of relatively higher exposure to U.S. Treasuries at a time when the risk/reward benefits of that exposure may not warrant it, WisdomTree collaborated with Barclays to introduce the Barclays U.S. Aggregate Enhanced Yield Index (Agg Enhanced Yield). The key idea is that the Agg can be broken into many subcomponents based on attributes such as sectors of the bond market, maturities, or credit
qualities. The Agg Enhanced Yield in effect reweights the Agg into areas that may have better risk/return attributes, rather than simply holding more of components that have increased in issuance. Looking at the resulting exposures:3
Instead of the nearly 40% that we saw in the Agg, the Agg Enhanced Yield was closer to 17%. It’s worth noting that this is very close to the maximum allowable under-weight to Treasuries relative to the Agg, set at 20%.
Instead of the corporate exposure being close to 24%, as seen in the Agg, the Agg Enhanced Yield’s exposure to this segment was closer to 45%.
• Government-Related & Securitized Exposures
: Differences here between the Agg and the Agg Enhanced Yield were much less pronounced, in the 2% to 5% range.
The main difference, therefore, involved taking the exposure to U.S. Treasuries—representative of a relatively poor risk/reward potential trade-off—and pushing it toward corporates. Doing this led to the yield to maturity of the Agg Enhanced Yield looking about 80 basis points (bps)
higher than that of the Agg4
. As a firm, given that we believe that the U.S. economic picture is on an improving trend that we expect to continue, we see more opportunity today in corporate credit
than we do in U.S. Treasuries.
Preparing for a “Low & Slow” U.S. Federal Reserve
For those who find the concept of reweighting the Agg of interest, see our recent blog post “Looking within the Barclays U.S. Aggregate Index to Enhance Income.”.
Source: Barclays U.S. Aggregate Index Factsheet, 5/5/14.
Sources: Bloomberg, Barclays, with data as of 9/30/15.
Sources: Bloomberg, Barclays, WisdomTree, with data as of 9/30/15.
Source: Bloomberg, as of 9/30/15.