WisdomTree

Fixed Income, Currency & Alternative, Income Strategies, Interest Rate Strategies

What Drives Returns (and Volatility) of the Barclays U.S. Aggregate Index?

by Bradley Krom, Fixed Income & Currency on October 19, 2015

Over the last couple of months, volatility across asset classes has ticked up markedly. Interestingly, although interest rates have declined from their highs of the year, rates haven’t fallen that much compared to the downdraft in global equity prices. As a result, the returns of the Barclays U.S. Aggregate Index (Agg) remain approximately unchanged year-to-date.

With interest rates low, the ability to generate returns remains constrained. In response, many investors have sought higher-yielding opportunities outside the Agg. While we also subscribe to this model, another compelling option in the current environment may be to look inside the Agg in order to generate more attractive returns. Below, we examine the rotation in performance among the various components of the Agg over the last five years.
 
Calendar Year Performance of the Barclays U.S. Aggregate Index
Calendar Year Performance of Barclays U.S. Agg Index

Lower for Longer

The elephant in the room for the Agg is that nearly 40% of its holdings are in U.S. Treasuries.1 With yields still low by historical standards, one way to generate returns in this segment of the market is for rates to stay low or decline. Indeed, with rates roughly unchanged year-to-date, the Treasury component of the Agg is up by less than 1%, yet it has been one of the largest contributors of volatility due to the updrafts and downdrafts in rates. Comparing 2015 to recent history, rising rates in 2013 led to negative total returns for the Agg. Given that the move in rates was the primary driver of returns, U.S. Treasuries led this decline.

In thinking about positioning in 2015, if investors believe that rates are likely to remain approximately flat or even lower, we believe they should be increasing their exposure to credit. With only one exception (2011), exposure to Baa credit actually improved performance compared to pure interest rate risk in Treasuries. With credit underperforming YTD, now could be an interesting time to increase allocations should an investor believe that any change in U.S. monetary policy will likely not have much of an impact on longer-term bond yields and credit conditions.
 
Lowest Volatility, Low Returns

So far in 2015, the primary drivers of bond volatility have come from the vacillating views of the Federal Reserve (Fed) action and widening credit spreads. Indeed, the best performing segments of the Agg have been in the securitized sector(asset-backed, mortgage-backed and commercial mortgage-backed securities). Compared to other components of the Agg, they tend to have the shortest duration and the least impact from widening credit spreads. While their positive returns and low volatility have been additive so far this year, historically these segments of the market have tended to provide modest returns. In fact, over the previous five years, they have tended to perform in the lower one-third of the various segments in the market. In light of tight valuations, we don’t see much of a catalyst for sustained outperformance.
 
A Potential Path Forward

In our view, while the Agg remains the de facto benchmark for many investors, its potential for income and total returns remains compromised. As a result, WisdomTree partnered with Barclays to create an index that enhances the yield of the Agg through a mechanical, rules-based process.

Among the constraints, the Barclays U.S. Aggregate Enhanced Yield Index (Agg Enhanced Yield) focuses on tracking error and sector caps relative to the Agg in order to maintain a comparable volatility profile, but with greater income potential. This goal is generally achieved by reducing exposure to U.S. Treasury securities and increasing exposure to credit.

While this approach has lagged by 30 basis points (bps) since its inception in July 2015, we believe the likely path forward could see credit outperform Treasuries in the medium term.2 The Agg Enhanced Yield should compete with the traditional Agg for core fixed income allocations: potential yield pickup of 81 bps with only a modest increase in duration.3 Given the risk investors have to stretch for in yield outside the Agg, shifting allocations within the Agg should be considered a more intuitive benchmark for core-focused strategies.

 
 
 
 
1Source: Barclays, as of 8/31/15.
2Source: Bloomberg, as of 10/8/15.
3Source: Bloomberg, as of 10/8/15.

Important Risks Related to this Article

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.

Barclays Capital Inc. and its affiliates (“Barclays”) are not the issuer or producer of the Funds, and Barclays has no responsibilities, obligations or duties to investors in the Funds. Barclays and the Barclays Indexes are trademarks owned by Barclays Bank PLC and licensed for use by WisdomTree with respect to the WisdomTree Trust as the Issuer of the Funds. Barclays’ only relationship with WisdomTree is the licensing of these Barclays Indexes, which is determined, composed and calculated by Barclays without regard to WisdomTree or the Funds. While WisdomTree may for itself execute transaction(s) with Barclays in or relating to these Barclays Indexes in connection with the Funds that investors acquire from WisdomTree, investors in the Funds neither acquire any interest in these Barclays Indexes nor enter into any relationship of any kind whatsoever with Barclays upon making an investment in the Funds. The Funds are not sponsored, endorsed, sold or promoted by Barclays, and Barclays makes no representation or warranty (express or implied) to the owners of the Funds, the issuer or members of the public regarding the advisability, legality or suitability of the Funds or use of these Barclays Indexes or any data included therein. Barclays shall not be liable in any way to the Issuer, investors or to other third parties in respect of the use or accuracy of these Barclays Indexes or any data included therein or in connection with the administration, marketing, purchasing or performance of the Funds. 

Foreside Fund Services, LLC, is not affiliated with the other entities mentioned.

Click to see more articles from this category