There’s More to Fixed Income Than the Barclays Aggregate

Chief Investment Officer, Fixed Income and Model Portfolios

05/01/2013

If stock investors are beholden to outperforming the S&P 500, bond investors have long compared themselves against the Barclays U.S. Aggregate Bond Index, the most widely followed benchmark for U.S. investment-grade fixed income. The Wall Street Journal recently¹ provided evidence of a trend we have noticed over the last two and a half years. Investors are starting to look at their exposure to the Barclays Agg and debating whether it is consistent with their investment objectives, given the changes in the global economy and the fixed income landscape. Yields are low, investors appear less than optimistic about further declines in interest rates, yet they continue to look to their fixed income portfolio to help generate income. Even with nearly $4 trillion currently benchmarked against the index,² the overall investable universe only accounts for roughly 38.6% of the world’s investable fixed income opportunities.³ As suggested by the article, a 1.00% increase in the Barclays Aggregate yield would likely trigger a 5.29% decline in price, far in excess of the cushion suggested by its 1.86% yield to maturity.⁴ In essence, investors are risking significantly more than they stand to gain even if interest rates do not increase in the next five years. In pursuing alternative exposures, investors are largely taking one of two approaches: • Complementing existing core fixed income positions with larger allocations to opportunistic fixed income sectors—high yield, bank loans and emerging market debt • Expanding their core allocations to include a broader universe of fixed income opportunities, with non-U.S. allocations and some exposure in non-investment grade We have been advocating similar approaches and believe there is considerable momentum left in this trend. In particular, dramatic improvements in the balance sheets of emerging market (EM) governments and corporations have resulted in investment-grade credit ratings for 95% of issuers of EM local currency sovereign debt⁵ and 73% of issuers in the EM corporate credit market. After an upgrade of the Philippines’ credit rating, the WisdomTree Emerging Markets Local Debt Fund (ELD) was comprised entirely of 100% investment-grade issuers at the end of Q1 2013.⁷ Expanding what investors consider core fixed income to include more non-U.S. dollar exposures and debt of global corporations is a trend we believe will continue to grow as investors increase their familiarity with this expanding opportunity set. We are also seeing rotation within opportunistic fixed income as local currency debt has received inflows at the expense of EM USD sovereign debt.⁸ Similarly, bank loan products have benefited from a moderation in the pace of flows into longer-maturity, high-yield bonds. As suggested by the chart below, sharp divergences in yield continue between opportunistic sectors and traditional core fixed income exposures. Opportunistic fixed income sectors entail an assumption of higher risk; but as we emphasized in our recent return driver blog, we believe the reward is worth these risks. Yield to Worst vs. Duration (as of March 31, 2013)

Yield to worst vs Effective Duration chart

U.S. high yield debt proxied by the Barclays HY 2% Constrained Index, EM local debt proxied by the JPMorgan GBI-EM Index, EM corporate debt proxied by the JPMorgan CEMBI Broad Index, U.S. aggregate proxied by the Barclays U.S. Aggregate Index, U.S. investment-grade debt proxied by the Barclays U.S. IG Corporate Index, and EM USD sovereigns proxied by the JPMorgan EMBI Global Index. Ultimately, how can investors target opportunistic sectors as well as expand their core exposures? WisdomTree offers several different approaches, with varying return drivers and performance profiles: • The WisdomTree Emerging Markets Local Debt Fund (ELD) is the largest ETF to invest in emerging market local currency debt • The WisdomTree Emerging Markets Corporate Bond Fund (EMCB) is the largest Fund to invest solely in EM corporate bonds • The WisdomTree Emerging Currency Fund (CEW) serves as a tradable proxy for short-dated EM fixed income • The WisdomTree Global Corporate Bond Fund (GLCB) expands the scope of corporate bond investing by packaging Western Asset Management’s best corporate credit ideas from around the world into an ETF ¹The Wall Street Journal, “Key Bond Index Gets Bitten,” 4/2/13. ²The Wall Street Journal, 4/2/2013. ³Comparing the Barclays U.S. Aggregate Index to the Barclays Global Aggregate Index, as of 3/31/13. ⁴+1.00% x 5.29 year duration = -5.29% move in bond prices. Note: Bond prices move in opposite direction of changes in interest rates. Based on the Barclays U.S. Aggregate Index data as of March 31, 2013. ⁵As represented by the JPMorgan GBI-EM Global Diversified Index, as of 3/31/13. ⁶As represented by the JPMorgan CEMBI Broad Index, as of 3/31/13. ⁷Source: WisdomTree, as of 3/31/13. ⁸Source: J.P. Morgan, 4/7/13.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Funds focus their investments in specific regions or countries, thereby increasing the impact of events and developments associated with the region or country, which can adversely affect performance. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Unlike typical exchange-traded funds, there is no index that the Funds attempt to track or replicate. Thus, the ability of the Funds to achieve their objective will depend on the effectiveness of the portfolio manager. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read the Funds’ prospectus for specific details regarding the Funds’ risk profile. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effect of varied economic conditions. As CEW can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting such issuers. Unlike typical exchange-traded Funds, there are no indexes that CEW attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile. ALPS Distributors, Inc., is not affiliated with Western Asset Management Company, sub-advisor for the GLCB and EMCB Funds.