The trends are clear. The past few years have seen a dramatic and warm embrace of passive investing across the capital market. Passive exchange-traded funds (ETFs) and passive mutual funds have dominated flows. Our worry, however, is that investors are feeling a false sense of security, particularly with passive bond portfolios—namely those funds and ETFs linked to a common benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg). There is nothing passive about this index, and we would argue it has been aggressively taking on more risk at the worst possible time. There are three main reasons for our concern: the simple math of bond duration, the changing composition of the index and the very logical financing behavior of corporate borrowers.
Bond math and duration
Without doing a rehash of intricate bond math, duration is an important calculation of bond risk. Although it has many variants, at its root, duration measures the sensitivity of a bond’s price to a shift in yields. For example, a bond (or a bond portfolio) with a duration of five years means that for every 1% shift upward in yields, there is a 5% drop in the price of the bond. Duration is measured in years because it is a function of the timing and magnitude of a bond’s cash flows (coupons and principal repayment): the more distant the cash flows, the higher the sensitivity (i.e., higher risk) to a change in interest rates, all else held equal. The cleanest example of this is the 30-year zero-coupon bond, which pays a single massive cash flow 30 years down the road. Therefore, this bond has a duration of exactly 30 years. There are no coupon payments along the way that would dampen its sensitivity to a change in yields. Generally speaking, the smaller the coupon, the higher the duration (and vice versa); the longer the maturity, the higher the duration (and vice versa). That’s just how the math of bond risk works.
Unfortunately for investors in passive bond portfolios or ETFs tied to the Agg, bond math is making this “safer” bond portfolio much riskier than it was even a few years ago. It is now much more sensitive to a possible rise in bond yields due simply to a lower “cushion” of coupons. As shown in the chart below, coupons have dropped dramatically since the financial crisis of 2008 and the introduction of quantitative easing by the Federal Reserve (Fed). For many years leading up to 2008, the Agg happily paid its investors a healthy coupon of 5% to 6%, but today and for the past few years it has been roughly half that amount. This is problem #1, the pure bond math of lower coupons has been extending the duration of the Agg.
Changing composition of the Agg
Problem #2 is that the Agg has dramatically changed its stripes since the financial crisis. Eight years ago, the largest bond sector was securitized loans (e.g., asset-backed securities and mortgage-backed securities), and most of these types of securities have shorter maturities and duration. Today, longer-dated Treasuries are now the dominant sector of the Agg, while securitized bonds have dropped off significantly. This, again, has shifted both the maturity and duration of the Agg upward.
Corporate financing behavior
If you were the CFO of a company over the past 10 years and every day you came to work seeing some of the most deliciously low interest rates you had seen in your career (or in your mother or father’s career, for that matter), there was one lesson and one lesson only: borrow as much as you can for as long as you can and exploit a marketplace starving for yield. The problem, however, is that many CFOs are doing the same thing and this behavior is changing the composition of the Agg as more corporations shifted their financing to longer-maturity bonds. The corporations are selling. Who’s buying all those longer-dated lower-yielding bonds? You are if you own an ETF or passive bond portfolio!
The net-net: More risk at the worst possible time
It was only a short time ago that the yield on the 10-year U.S. Treasury hit 1.37%, the lowest yield ever recorded in American history. While of course it was possible that rates could have gone lower, prudence dictated that this was a period to be reducing risk by either shortening duration or reducing bond exposure. What has the Agg been up to these past few years? Just the opposite. The chart below clearly shows this to be the case.
The bond math of lower coupons, the changing composition of the Agg, and the issuance of longer-maturity bonds by corporate America all conspired to increase risk at possibly the worst time. By any reasonable fiduciary standard, this was a time to be reducing duration, yet the Agg, and the passive bond portfolios and ETFs tied to it, has seen a 63% increase in duration over the past nine years. There is nothing passive about the Agg—it has actually become more aggressive! Be careful.