For many market analysts, the Bloomberg Barclays US Aggregate Bond Index, the most popular index for passive bond funds and the most popular benchmark for most U.S. bond funds, never made much sense because it is heavily weighted toward issuers with the most debt. That does not bode well for performance or safety.
In the current market, the Agg, as it’s called, is even more vulnerable because its duration, which measures the sensitivity of bonds to interest rate changes, has lengthened, and the credit quality of its corporate bond component — which accounts for about 25% of assets — has declined, according to Peter Chiappinelli, portfolio strategist and member of the asset allocation team at Grantham Mayo Van Otterloo & Co.
The duration of the Agg is now around 6, up from about 3.5 in 2008, while half the credit rating of its corporate bonds — all investment grade — are BBB, just above junk status, which is the highest BBB rating level since 2008. Moreover, the yield spread between BBB-rated and AAA-rated bonds has narrowed to near 100 basis points, and the ratio of debt to EBITDA among those bonds is about 2.4 times — higher than levels seen before the 2000-2001 or 2008-2009 recessions, according to Chiappinelli.
S&P Global Ratings recently reported that the downgrade potential of the U.S. corporate bond market has reached its highest level since late 2016 as the economy slows during the longest economic expansion in U.S. history
“This is the riskiest bond market in years in terms of duration and most risky ever in terms of credit,” says Chiappinelli. “Bonds have never been more expensive than now and never been more risky from a value manager’s point of view … Investors are getting paid less for taking on more risk.”
But they are pouring money into passive bond markets, and the Agg is the underlying index for many of those funds, including Vanguard’s Total Bond Market ETF (BND) and Total Bond Market Index Fund (VBMLX and VBTLX) and the iShares Core U.S. Aggregate Bond ETF (AGG), and the benchmark for those funds as well as others.
In the one-year period through Sept. 30, flows into passive taxable bond funds almost reached $153 billion compared with $59.5 billion into actively managed taxable bond funds, according to Morningstar’s latest fund flow report for mutual funds and ETFs.
The U.S. Agg today consists of about 40% Treasuries; 30% securitized debt, mostly mortgage-backed securities; 25% investment-grade corporates and “other,” including a smattering of municipal bonds and sovereign debt. In 2008, Treasuries, which have lower yields than mortgage-backed securities were just 22% of the Agg while securitized debt comprised 45% and investment-grade corporates 20%.
Chiappinelli says that investors should not be taking comfort in the fact that the Agg is now dominated by Treasuries “because now all those Treasuries have lower yields and longer maturities and duration is extremely high at the lowest yields in U.S. history.”
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