Stop Benchmarks From Biting Your Bond Portfolio

Transcription

1 Schwab Center for Financial Research Stop Benchmarks From Biting Your Bond Portfolio Kathy A. Jones Vice President, Fixed Income Strategist

2 Many fixed income benchmarks weight heavily toward U.S. Treasury and agency securities and may be riskier than some bond investors realize. What should investors do? We looked at bond sectors outside of a traditional core U.S. bond portfolio to determine where to diversify without adding significant risk. Kathy A. Jones Vice President, Fixed Income Strategist, Schwab Center for Financial Research Kathy A. Jones is responsible for credit market and interest rate analysis, as well as fixed income education for investors at Schwab. Jones has studied global credit markets extensively throughout her career as a fixed income investment strategist, working with both institutional and retail clients. 2

3 Executive Summary The broad bond benchmarks including the most common one, the Barclays U.S. Aggregate Bond Index are heavily concentrated in government and government-related securities. Although those weightings increase the overall credit quality of the indices, they present two key risks for investors a lack of issuer diversification and increased exposure to rising interest rates. Corporate bonds and international bonds issued by developed and emerging-market countries and corporations can help to mitigate those risks. These types of bonds diversify holdings. Some offer better yields than U.S. government securities, and some of the issuers have lower debt levels and faster economic growth. Not all companies and countries, however, are created equal. Investors looking for broader exposure to a range of fixed income sectors need to understand the credit risk they may be taking in exchange for lowering their interest rate risk. Relying on benchmarks weighted heavily toward U.S. government bonds could leave you under diversified and overexposed to rising interest rates. Why is this issue important now? A large number of bond mutual funds and exchange-traded funds (ETFs) track broad bond indices, and investors may not recognize that these funds are heavily weighted in U.S. government securities. This can be a problem for two reasons: First, the bond yields and coupons in government securities are near historic lows, presenting substantial interest rate risk if yields rise. Second, the indices exposure to mortgage-backed securities could mean that the average duration of the portfolio increases when interest rates rise. While we don t believe there is an imminent threat of rates rising sharply, they probably won t stay at these historic low levels forever. 3

4 What does Schwab recommend? Investors may look to diversify their fixed income portfolios away from common benchmark indices, adding some corporate and international bonds. This may, however, mean adding other risks. We are not making the case, for example, that investors should heavily weight their entire core fixed income portfolios toward lower-rated corporate or emerging-market debt. But they may benefit from greater diversification. For most investors, the challenge in expanding their core portfolios will be access to other types of bonds as well as the expertise to choose securities. Significant expertise is required to navigate the U.S. and global bond markets. For this reason, the best way to expand a core portfolio, in our view, will often be through professional managers, including mutual funds or ETFs to add broader exposure in fixed income portfolios. Consider using the Schwab Mutual Fund Select List or the Schwab ETF Select List or turning to professional management to help expand a core bond portfolio. I thought index-type bond funds give me exposure to the broad bond market, meaning I don t have to worry about picking and choosing individual bonds. Is that not correct? Using a mutual fund or an ETF that tracks a broad bond index is a common strategy. We think changes in the bond market over the past few years, however, mean that the broad index approach doesn t have the same benefits it once did, and might even be making your portfolio riskier than you realize. The main reason it is riskier is that since the financial crisis, government and government-related bonds have dominated major aggregate bond indices, such as the Barclays U.S. and Global Aggregate Bond Indices. If you look at the makeup of the U.S. index, only a small portion is in corporate bonds; the rest is made up of bonds backed by the Treasury. This is especially true in the U.S. Changes in the bond market over the last few years have rendered traditional index strategies less effective. 4

5 now that Fannie Mae and Freddie Mac have moved into conservatorship as a result of the financial crisis. In the chart below, you can see that 78% of the U.S. aggregate index is made up of Treasury bonds (36%); securitized bonds (32%), such as mortgagebacked securities issued by entities like Fannie Mae and Freddie Mac; and bonds issued by other government entities (10%). This means that when you buy an index-type product, you are investing in a fund that is not diversified by issuer. Treasury allocations have increased over the past decade Securitized 39% Treasuries 22% Securitized 32% Treasuries 36% Corporates 22% Government Related 17% Corporates 22% Government Related 10% Source: Barclays. Data as of April 30, Why is this a problem? For my core bond portfolio, don t I want more exposure to high-quality bonds and very little credit risk? We think it s absolutely a good idea to have some of your core bond holdings in high-credit-quality bonds. Treasury bonds have been one of the best sources of diversification from stocks and other riskier asset classes over the past five years. But we re concerned that the indices people use for their core holdings are now too heavily concentrated in Treasury-backed bonds. Besides a lack of issuer diversification, there are more risks associated with a large holding in government bonds than there were a few years ago. A big concern is interest rate risk. Due to the Federal Reserve System s policies, 5

6 interest rates on Treasury bonds have fallen to historic lows. Now that the housing agencies Fannie Mae and Freddie Mac are in conservatorship, their yields have fallen along with Treasury yields. With the Fed holding down the rates on Treasury bonds through its quantitative easing program, a large portion of the index is more vulnerable to rising interest rates. Aren t all bonds vulnerable to rising rates? Why is this such a concern with the aggregate index? Is it just the high proportion of government bonds? Part of our concern is that rates for Treasury bonds are near historic lows, so there isn t much room for them to fall when the Fed changes its policy. But it s also that the duration of the bonds in the index has risen significantly, which increases the interest rate risk. In the upper right corner of the chart below, you can see that the duration of the index stands at over 5, which is near the all-time high, and it appears likely to continue to rise. The securitized bonds are largely mortgage-backed securities, 6.0 Duration is rising Duration Barclays U.S. Aggregate Bond Index Average Source: Barclays. Data as of April 30, Duration measure shown is modified duration. 6

7 which are sensitive to interest rate changes. If and when interest rates rise, there will be fewer people able to refinance their mortgages. The result is that the duration of mortgage-backed securities will tend to increase as rates rise. The longer the duration of the index, the greater the interest rate sensitivity. If interest rates rise, the value of the index will fall (all else being equal). What if I try to diversify into a global aggregate index? Won t that provide some diversification? Global diversification can certainly help, but if you use the Barclays Global Aggregate Bond Index, you ll face some of the same issues and risks. Much like the U.S. index, the bulk of the Barclays Global Aggregate Bond Index is composed of government bonds, which are mostly issued by large developed countries. Compared to 10 years ago, the government bond component has moved from 46% of the global aggregate index to 54%. Also, these indices are weighted by market capitalization, meaning that whatever entity issues the most bonds gets the most weighting in the index. In the global index, that means the most heavily indebted countries have the highest representation something you may not necessarily want. For example, U.S. bonds make up 37% of the index, Japanese government bonds make up 17%, and the Eurozone and the U.K. The Barclays Global Aggregate Bond Index s country and sector breakdown United Kingdom 6% Japan 18% Other 18% United States 37% Corporates 16% Securitized 16% International Treasury Bonds 54% Eurozone 24% Government Related 14% Source: Barclays. Data as of April 30,

8 combined make up another 30%. These are countries and regions with slow growth, high debt, and some of the lowest yields in the global marketplace. Once again, there are only a handful of issuers representing a high proportion of the overall index, and the bond yields for these countries are near historic lows. The bottom line is that an investor relying on the broad aggregate indices for their core holdings is getting exposure to a low-yielding, long-duration portfolio of bonds issued by a handful of highly indebted countries. That may not be what most people want for the bulk of their bond portfolio. If I move beyond the U.S. and global aggregate indices, aren t I adding credit risk? We re not telling investors to abandon their government debt securities or that an aggregate index can t still play a role in their bond portfolios. But we think that investors need to move beyond the core for some of their holdings in order to get more issuer diversification and reduce interest rate risk. Now, it s true that if you re trying to limit duration risk you ll have to take on more credit risk in this market if you want to increase yield. We think you can achieve this by looking beyond the usual passive approach of using an indextype fund for all of your core holdings and adding other types of exposure. This doesn t mean throwing caution to the wind and abandoning Treasury bonds or other low-credit-risk bonds, though it means expanding the core for some of your bond portfolio. What are my choices? Which bonds should I consider? The choices include corporate bonds and perhaps emerging-market bonds. There is a spectrum of risk and return you need to think about when making these changes. The chart on the next page illustrates the yields that are available when taking different kinds of risks, ranging from Treasury bonds to 8

9 sub-investment-grade or high-yield bonds. We think that increasing the proportion of your holdings in investment-grade corporate bonds and emergingmarket bonds, however, would add a bit more yield while not increasing interest rate risk. 6% Yields higher than 2% are harder to find 5% 5.21% 4.65% Yield to Worst 4% 3% 2% 2.60% 2.34% 2.06% Fed Inflation Target Rate 2% 1.49% 1% 0.81% High Yield Emerging- Investment Market Grade Local Currency Government Agency Mortgage- Backed Municipal International Non-USD Treasury/ Agency Source: Barclays. Monthly data as of April 30, The indices representing the investment types are the Barclays U.S. Corporate High-Yield Bond Index (High Yield), Barclays EM Local Currency Government Index (Emerging-Market Local Currency Government), Barclays U.S. Corporate Bond Index (Investment Grade), Barclays Municipal Bond Index (Municipal), Barclays U.S. MBS Index (Agency Mortgage-Backed), Barclays Global Aggregate ex-u.s. Bond Index (International Non-USD), and Barclays U.S. Government Bond Index (Treasury/Agency). How do I decide how much risk to take in these sectors? Let s first look at corporate bonds. We think adding investment-grade corporate bonds with average maturities in the four- to seven-year range can be a way to add yield to a portfolio without moving too far down in credit quality or taking too much duration risk. In our view, the underlying fundamental 9

10 outlook for U.S. investment-grade corporate bonds is solid. Companies have reduced leverage on their balance sheets, and default rates are low relative to history. According to the chart below, companies have much less debt on their books than they ve had in years. And according to the chart on the next page, the number of defaults among highly rated companies is paltry. If the economy continues to grow, even at a relatively modest pace, we don t anticipate that defaults will increase significantly. U.S. corporate leverage is declining 5 Net Debt / EBITDA Ratio Note: Corporate leverage is a measure of a firm s debt relative to its earnings. We define leverage as net debt divided by EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it, and it can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Source: Bloomberg. Data as of March 29, Reported data are representative of the S&P 500 Index. 10

11 60 Higher rated bonds tend to have fewer defaults Cumulative 15-Year Average Default Rate (%) Standard and Poor s credit rating scale AAA AA A BBB BB B CCC Source: Schwab Center for Financial Research with data from Standard & Poor s 2012 Global Corporate Default study. The study analyzed the rating and default history of 15,299 U.S. and non-u.s. companies first rated by Standard & Poor s between December 31, 1981, and December 31, The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results. We also believe that valuations are reasonable, relative to the long-term trend. The interest rate difference between IG corporate bonds and Treasuries is near the long-term average. Given that default rates are below average and the spread is near the average, we think that indicates a reasonable valuation. The yields on corporate bonds are still pretty low. What about higher-yielding bonds? Should I consider them? Most of the other bond categories fall into the aggressive income category, so you want to be somewhat cautious. However, we think another area where adding exposure might be worthwhile is emerging-market bonds. Over the past 10 or 15 years, the underlying fundamentals for the emerging-market bond 11

12 world have improved. In general, emerging-market countries have less debt relative to the size of their economies, stronger growth, and better demographic trends than developed countries. General Government Gross Debt in 1% of GDP Debt ratios are lower for emerging-market economies IMF Estimate G-20 Advanced Economies G-20 Emerging Economies Note: Gross debt consists of all liabilities that require payment or payments of interest and/ or principal by the debtor to the creditor at a date or dates in the future. This includes debt liabilities in the form of special drawing rights (SDRs), currency and deposits, debt securities, loans, insurance, pensions and standardized guarantee schemes, and other accounts payable. Thus, all liabilities in the GFSM 2001 system are debt, except for equity and investment fund shares and financial derivatives and employee stock options. Debt can be valued at current market, nominal, or face values. Data from 2011 onward are IMF estimates. Source: International Monetary Fund (IMF), Fiscal Monitor, as of April Perhaps more importantly, we think the trend in emerging-market countries has been to more open economies, more independent central banks, and much lower inflation trends. That s not true of all countries certainly, but that s been the overall trend. And it has been reflected in the trend in upgrades and downgrades of emerging-market countries compared with developed-market countries. The chart on the next page, which includes a selected list of emerging-market countries, shows that there has been an upward bias in rating actions, with many countries moving from sub-investment grade to investment grade. 12

13 Emerging-market countries: Upward trend in credit ratings 8 AA+ AA- AA- AA- Credit Rating BBB BB BBB- BB+ BBB+ BB BBB A- BBB+ A- BBB BBB BB+ BB+ B+ B+ BBB ḆBB -8 B- Investment-Grade Threshold = BBB- -12 China SD/D India Indonesia Taiwan Hungary Russia Poland Turkey Brazil Mexico Chile South Africa Source: Standard and Poor s credit ratings. Data as of May 15, It is worth noting that market-cap weightings are basically backward looking and rely to a large extent on credit ratings and may not capture changes as they are taking place. We think emerging-market bonds are in that category. Prior to the financial crisis, yields on emerging-market bonds were falling relative to yields on developed-market bonds. We believe the market s assessment was that, collectively, the risks in these markets were falling. However, the credit ratings were slow to change compared to the market yields. Consequently, many emerging-market bonds were not included in the indices until the bond ratings rose. 13

14 Can I take an index approach to emerging-market bonds? It is hard to access specific emergingmarket bonds as an individual investor. Concentration risk is also an issue with emerging-market bonds. The Barclays EM Hard Currency Aggregate Bond Index is fairly concentrated by issuer. As of April 30, 2013, Brazil, Russia, and Mexico made up more than 33% of the index. We think this might give you too much exposure to a small number of countries with a relatively high level of debt while ignoring countries with lower debt relative to GDP. We also think it s important to choose country exposure carefully, and the index approach makes that difficult. Besides diversification, what are other advantages to holding emerging-market bonds? On the issue of diversification, remember that emerging-market bonds provide some diversification from other types of bonds, such as U.S. Treasuries and U.S. corporate bonds. However, they are more highly correlated with equities than U.S. Treasuries. Therefore, the diversification benefit is only within the fixed income segment of your portfolio not necessarily the entire portfolio. On the plus side, let s not forget about the yields in emerging-market countries. They ve come down a lot, but they re still considerably higher than in developedmarket countries. The chart on the next page shows that the spread between emerging-market bond yields and global bond yields is still pretty wide. 14

15 15 Emerging-market bonds have higher yields 12 Yield to Worst (%) Barclays EM USD Aggregate Bond Index Barclays Global Aggregate Bond Index Source: Barclays. Monthly data as of April 30, What are the risks? Won t emerging-market bonds and even corporate bonds add more risk to my core bond portfolio? From a credit perspective, you will be taking more risk. Additionally, emergingmarket bonds are not as liquid as the U.S. Treasury market, so in the event of a market decline, you might have difficulty finding a buyer for the bonds. We saw this happen in 2008 during the global credit crisis when financial markets were stressed. A third risk is currency risk. Many emerging-market bonds are issued in U.S. dollars, but an increasing number are being issued in local currencies, which introduces the potential for currency risk. All of these factors can add to the volatility of a portfolio. Doesn t it seem counterintuitive to reduce risk by shifting to some of these non-core sectors of the bond market? For conservative investors who think of fixed income as the safe part of their portfolios, this shift may not be appropriate. Investors who have a high level of exposure to credit risk in their equity portfolios may not benefit from this 15

16 strategy either. Even for those investors, however, it s important to recognize that the index approach to investing in bonds could potentially involve risks they weren t aware of, such as greater interest rate sensitivity. Who might this strategy be appropriate for? For those who can tolerate a bit more potential volatility, we suggest balance and diversification. Most investors should not eliminate their entire allocation to government bonds and other highly rated securities. Expanding beyond the traditional index-type core bonds approach should provide the positive benefit of less issuer concentration and reduced interest rate risk. But the trade-off is somewhat more credit risk and reduced liquidity. It s important to find the right balance when adding these risks to your portfolio. What s your parting recommendation? I m not sure how to go about buying corporate bonds, let alone emerging-market bonds. How would I implement these changes? We think many investors would be better off using professional management when approaching these markets. The global bond markets are large and can be complex. Conducting your own research on the creditworthiness of companies can be difficult and time-consuming. Researching emerging-market economies generally requires specialized understanding of specific regions. For most people, it makes sense to use either a managed account or an actively managed mutual fund when adding exposure outside of the usual core bond holdings. One strategy is to use a mutual fund that has a broad mandate to invest outside of and away from the core U.S. bond indices. Some intermediate-term bond fund managers have this broader flexibility. Investors could also use dedicated sector funds, such as global, world bond, corporate bond, or EM bond funds, to expand their core fixed income holdings. Researching emergingmarket bonds can take time and specialized knowledge. For most people, it makes sense to use either a managed account or an actively managed mutual fund. 16

17 Important Disclosures Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by visiting Schwab.com or calling Please read the prospectus carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV). The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lowerrated securities are subject to greater credit risk, default risk, and liquidity risk. International investments are subject to additional risks, such as currency fluctuations, geopolitical risk, differences in financial accounting standards, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. Indices are unmanaged; do not incur management fees, costs, or expenses; and cannot be invested in directly. The Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. The Emerging Markets Barclays Local Currency Government Index is composed of local currency Treasury debt from 22 countries with a sovereign rating of A1/A+ or a World Bank income classification of Low, Low/Middle, or Upper/Middle. The Barclays U.S. Corporate Bond Index covers the USD-denominated, investmentgrade, fixed-rate, taxable corporate bond market. Securities are included if they re rated investment grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody s, S&P, and Fitch. This index is part of the U.S. Aggregate. The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term, tax-exempt bond market. The Barclays U.S. MBS Index covers agency mortgage-backed pass-through securities (both fixed rate and hybrid adjustable-rate mortgage) issued by Ginnie Mae, Fannie Mae, and Freddie Mac. The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade, fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian- Pacific Aggregate Indices. The Global Aggregate ex-u.s. Bond Index excludes the U.S. Aggregate component. The Barclays U.S. Government Bond Index is an unmanaged index considered representative of fixed income obligations issued by the U.S. Treasury, government agencies, and quasi-federal corporations. The Barclays EM USD Aggregate Bond Index includes USD-denominated debt from emerging markets in the following regions: the Americas, Europe, the Middle East, Africa, and Asia. As with other fixed income benchmarks provided by Barclays, the index is rules based, which allows for an unbiased view of the marketplace and easy replication. The Barclays U.S. Aggregate Bond Index represents securities that are SECregistered, taxable, and USD-denominated. The index covers the U.S. investmentgrade, fixed-rate bond market, with index components for government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The S&P 500 Index is a marketcapitalization-weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CS ( ) PLC74746FM-01 (06/13)