One of the questions we get asked from time to time is why we don’t just buy one bond index for the bond or fixed-income portion of client portfolios, and call it a day. Wouldn’t that be easier and cheaper, some clients ask?
Yes, it probably would be easier (only one bond investment to buy) and cheaper (an index fund has very low annual expenses).
But, unfortunately, it wouldn’t be better for you. While we do buy bond index funds for client portfolios, we rarely buy just one bond index fund for portfolios.
To understand why, we need to look at the composition of the primary bond benchmark, and how it’s changed as a result of the 2008 credit crisis.
What’s the most popular bond benchmark? The most commonly used bond index in the U.S. is the Barclays U.S. Aggregate Bond Index (known as the Lehman Aggregate until 2008). At last measure, it contained about 8,200 fixed income issues worth roughly $16 trillion (about 43% of the overall U.S. bond market).
What is the index used for? The index often serves as a proxy or benchmark for the overall bond market, and we often compare real-life bond performance to the index. You can’t buy or sell the actual index, so several investment companies use the index as a model to develop index funds and exchange traded funds that investors can actually buy, like the iShares Barclays Aggregate Bond (AGG) or the Vanguard Total Bond Market (BND) exchange traded funds.
What is included in the index? The index replicates the U.S. investment grade bond market based on market weight, meaning the most widely issued bond types have the heaviest weighting in the index. Types of bonds included in the index are Treasury bonds, government-related issues, corporate bonds, mortgage- and asset-backed bonds.
What is excluded from the index? It’s important to understand that the index measures an incomplete bond universe. Many types of bonds are excluded from the index, such as non-taxable bonds like municipals, non-US dollar denominated bonds, variable rate bonds, high-yield bonds, and TIPs (Treasury inflation-protected securities).
Why does this matter? If you understand the composition of the bond aggregate index, you understand its strengths and weaknesses.
First, the index is dominated by high-quality, low-yielding government bonds and will perform best when fear abounds. In 2007, government bonds made up an estimated 35% of the index. Due to the 2008 credit crisis, government bonds now make up a whopping 75% of the index. The growth stems from heavy issuance of government debt during the crisis, and the government takeover of mortgage issuers like Freddie Mac and Fannie Mae.
When fear levels are high and there is a “flight to quality,” the index is likely to strongly outperform other bond investments. When the outlook brightens (like in the first quarter of 2012), or interest rates threaten to rise, the index may dramatically underperform other bond investments, as investors seek out higher-yielding bonds elsewhere.
This doesn’t mean you shouldn’t buy the index. It just means that if you do, you are investing in something that looks and acts a lot more like a government bond index than anything else.
Second, the index underweights or totally excludes many bond sectors that help to diversify your bond portfolio and enhance returns, especially sectors that may shine if interest rates climb. So while the bond index may be a useful component of your fixed-income portfolio, it will rarely be a one-stop shopping solution. If you are in a higher tax bracket, you need to look outside the index for muni bond exposure. If you seek higher levels of income, you’ll want to look elsewhere for riskier, but higher yielding bonds. To protect yourself from future inflation, you need to look outside the index for variable or inflation-adjusted bonds.
The bottom line: The bond index, and investment products that replicate it, may be useful as a core fixed-income holding. But it’s a rare portfolio that is well served by relying on the index as an exclusive bond holding. In bonds, just like with stocks, it’s important to diversify holdings and use multiple strategies to help you focus your portfolio on the sweet spots in the market. Think of your portfolio like a tool box. If the only tool in your box is a hammer, you’ll find it hard to get most jobs done. While a hammer is handy to have, you’ll need other tools as well to finish the project. A bond index is no different. It’s a useful addition to your portfolio tool box, but it’s definitely not enough to build the house of your dreams.