Is There a Better Investor Solution than the Fixed Income Index?
Passive fixed income solutions, once perceived to be the answer to low risk investing, are no longer holding up against a changed market landscape. Interest rates – already in a downward trend for 40 years – are approaching zero. Rates have been driven down by consumer deleveraging during the financial crisis and the Federal Reserve’s newest version of quantitative easing. Fixed income, once a source of income, liquidity, and capital preservation, is now a reach for yield and the hope of some mediocre cash flow. Though traditionally told to “wait it out” during down markets, investors that want exposure to fixed income via traditional methods such as 60/40 balanced funds, target-date funds, or index funds, now require a different approach. The risk of complacent investing is no more evident than those using index or beta products for their fixed income allocation. At Build Asset Management, we believe this different investment environment requires a new approach to fixed income investing. As will become evident, the risk/reward profile of many passive fixed income strategies and indexes are stretched.
This article will look at the genesis of fixed income indexes, how they have been used, and the state of index funds today. It will explore some of the product’s deficiencies and how those deficiencies are exacerbated in today’s market climate. Lastly, it will explore Build’s approach to fixed income portfolio management and construction and why we believe our approach is right for the changing fixed income landscape.
Origins of the “Index”
The precursors to what is now known as the Bloomberg Barclays U.S. Aggregate Bond Index (referred to in this piece as the “Agg” or “Index”) was co-created on July 7, 1973 by Art Lipson and John Roundtree, both of Kuhn, Loeb & Co., a boutique investment bank.[1] Lipson and Roundtree created two total-return indexes focused on US bonds: the US Government and the US Investment Grade Corporate Indexes. The indexes were blended in 1979 to form the Government/Credit Index. In 1986, mortgage-backed securities were also added to the index, which was renamed the Lehman Brothers US Aggregate Index and was backfilled with historical data to 1976.[2] After Lehman Brothers bankruptcy assets were acquired by Barclays Capital, it was renamed the Barclays Capital Aggregate Bond Index.[3]
The index was acquired by Bloomberg L.P. in August 2016 as part of a larger sale of the Barclays Bank’s index and risk analytics business. The index was subsequently renamed the Bloomberg Barclays US Aggregate Bond Index. Upon its acquisition, Bloomberg and Barclays announced that the index would be co-branded for an initial term of five years.[4]
Development of Index Funds
On August 31, 1975 Vanguard’s Jack Bogle launched the First Index Investment Trust, a fund designed to match the S&P 500. The fund didn’t immediately take off with investors and didn’t achieve $1B in assets until 1990.
Vanguard’s fixed income indexing capabilities dated back to 1986, with the launch of the first ever bond index fund, Vanguard Total Bond Market Index Fund (VBTLX). This initial effort was the first time that investors could obtain broad exposure to various fixed income sectors, incorporating a large swath of investment-grade quality issuers based on a rules-based inclusion mechanism. This new investing methodology seemed to be gaining some traction in the equity space, and now fixed income investors had a chance to participate in a similar way.
However, what was successful for equities in index form was fundamentally difficult to achieve in fixed income. What was believed to be the benefit of diversification in fixed income index investing delivered unintended consequences of additional credit and sector allocation risk. The rules-based methodology used to determine which securities are included in the index created unforeseen concentration risk, a slow march to lower and lower yields, and additional interest rate risk.
A byproduct of this concentration risk is the inverse relationship that has formed with the divergence between the Index’s extending duration and its plummeting yield. As more and more constituents were added to the Agg, certain sectors and securities comprised a larger portion of the Index, causing imbalances and adding to the unforeseen consequences created by this rules-based methodology.
It seems clear that, particularly in fixed income, investors take on more risk, not less, by using passive strategies. Despite this divergence in risk/return and other potential problems, passive strategies in fixed income and other asset classes still comprise a significant market share.
This phenomenon is captured in a snapshot of recent allocations to active and passive strategies:
To understand how this risk concentration occurred and how the complexion of the Agg changed over time, we will review how the Agg was created and is currently managed.
How the ‘Agg’ is Built
The Agg is constructed based on a series of rules or requirements that include a bond’s currency, sector, credit quality, amount outstanding, time to maturity, country of risk, taxability, subordination, and placement type (public or private). The rules can be very detailed for each index and are described well in ‘The Bloomberg Barclays Methodology’. For this paper, we posit that the Agg consists of securities that are denominated in US dollars; are investment grade quality or better; have at least one year to maturity; and have an outstanding par value of at least $100 million (but had issuance size between of at least $250mm to $1B, depending on asset type).
Interestingly, it is this rules-based construction that exposes the potential problem for investors using the Agg of gaining exposure to a “generic”, high quality fixed income portfolio. If an issuer or security meets the criteria of the rule, it must be included in the Agg, even if this results in overexposure to a particular sector or issuer.
In an actively managed portfolio, this sector exposure is significant and complex and is the key focus of the portfolio management team.
Surprisingly, the Bloomberg Barclays US Aggregate Index is not a United States-only index. Suppose one looks back at the non-US sovereign exposure an investor would be taking on by owning the Agg as recently as 2011. In that case, they will find issuers that included Brazil, Mexico, Columbia, and Peru, to name a few. Investors who decided to avoid the Agg until after mid-2010 would have avoided owning Greece[7], which was downgraded to “split-rated” in June of 2010, meaning it was removed from the Agg. While one perhaps thought they were investing in a “United States” index, they were taking on the sovereign and political risks of arguably unstable, developing economies. To be clear, many of these developing economies are still included in the Agg, with others like the Philippines, Uruguay, and Panama being recent additions. For those concerned about some of our own states’ financial health, the Agg also owns taxable, general obligations from the likes of the State of California. [8]
In an actively managed portfolio, this sector exposure is significant and complex and is the key focus of the portfolio management team. It requires expert analysis by individuals who are well-versed in standard credit and financial analysis, but who also likely understand the political environment in the countries they cover. The Agg’s approach is to include various sovereign issuers if they check the required rule boxes at the time. There is nothing forward-looking in the methodology’s practice.
Another sector problem was the allocation to subprime mortgage exposure during the financial crisis. This exposure included many AAA rated securities when the bonds were issued. The problem, of course, was how these highly-rated bonds were structured. While the rating agencies were comfortable that these securities had structural defensive mechanisms, the underlying mortgages that backed the bonds were loans from less-than-credit-worthy borrowers. Ultimately, those creditors defaulted at such a rate that the structured products’ defensive measures were eaten away and collapsed, rendering many of those formerly AAA securities worthless.
The matter of sector diversification or, more accurately, sector concentration is significant. It is highlighted in the Index’s allocation to U.S. Treasuries. As issuance in U.S. government securities exploded during the 2008 financial crisis, and again emerging from the Coronavirus pandemic, U.S. Treasury exposure is over 37% of the index as of February 26, 2021. Compare this to about 24% in 2004 – a 54% increase in that sector’s exposure. Looking back at the duration-yield divergence graph we see that investors – by doing nothing other than being long this index – have assumed significant interest rate risk and are compensated with ever lower yields.
This sector concentration in the Agg feeds into the associated problem of “security selection,” another key tenant of active portfolio management. Security selection is the process used by active managers to determine the issuers and issues and the issuers individual securities they want to include in their portfolio. Since the Agg uses a rules-based checklist to predetermine if an issuer’s particular security meets the Index qualification, there is no forward-thinking analysis of a specific security from a fundamental credit analysis understanding. As a result, the Agg is more likely to include issues of issuers many active managers would likely not own. One example of an issuer and its bonds that have fluctuated within the Agg is Ford Motor Company. Looking at one of Ford’s old 30-year bond issues, the 6.625% October 1, 2028, we find an issuer rated A1 by Moodys and A by S&P at its issuance in 1998. At this point, Ford met all requirements for its inclusion into the then Lehman Aggregate Bond Index. However, by July 2005, Ford’s economic position had become precarious enough that the major rating agencies had downgraded Ford to below investment grade. Hence, the bond was removed from the index. The bond remained “junk” until May 2012 (it achieved a low rating watermark of ‘D’ and ‘CA’ at the height of the financial crisis), when it was upgraded to investment grade and put back into the index. However, when the rating agencies again lowered Ford’s ratings below investment grade in March 2020, it was removed from the index and remains so today. [9]
Active managers certainly had the opportunity to purchase this Ford security, at issue or in the secondary market, depending on their analysis of the issuer and the merits of this specific bond. But in no way was the active manager ever required to own this issue like an index is required to own a security if it meets the rules criteria. Given Ford’s volatile balance sheet, active managers have the clear advantage by avoiding this type of bond.
Why Seek an Alternative?
With this myriad of reasons to avoid using index funds, one could ask, “why use the Agg?” Some investors seem to favor lower fees and the relative ease of use of an index fund. While others buy into the perception of higher liquidity of the index fund. Hopefully it is clear from the analysis of the Agg’s construction above, that there are many hidden risks for an investor. Any perceived “better liquidity” is more than offset by the additional risks embedded in the Agg. Additionally, this table from eVestment highlights that low cost, active fixed income managers have outperformed passive managers over a 10-year period, with Intermediate-Term Bond and Corporate Bond active funds outperformer 70-80% of the passive funds.
The New Approach?
If you agree with our argument that the Agg has not provided better liquidity or diversification, then today’s investors may not have been well served by the index. Build Asset Management is redefining fixed income investing and risk management in a world of ultra-low interest rates and asymmetric risk with next-gen solutions combine the best of active fixed income management with a quantitative framework options overlay. Build creates its portfolios on a sector-by-sector, then bond-by-bond basis. The portfolio management team analyzes every security held in the vehicles for each strategy. The portfolio managers and analysts focus on fundamental credit analysis, sector, and security selection and are mindful to eliminate those securities that pose undue credit or duration risks. It sets Build apart from passive, indexing vehicles. Advisors or investors seeking a repeatable, actively managed solution to solve for some of the Agg issues we’ve discussed should consider Indexed Risk Control strategies. To find out more and see how it could fit into your portfolio visit our solutions page.
[1] Bloomberg Barclays US Aggregate Bond Index – Wikipedia
[2] Today in Market History, The First Index Fund – The Irrelevant Investor – Wikipedia
[3] U.S. Passively Managed Funds Outdraw Actively Managed Funds In 2019 | Seeking Alpha
[4] What is the Agg or Bloomberg Barclays Aggregate Bond Index? (investopedia.com)
[5] Bloomberg
[6] Refinitiv Lipper
[7] World Government Bonds, Greece Credit Rating
[8] Bloomberg
[9] Bloomberg
