The Hidden Risks of Fixed Income Indexing A White Paper by Manning & Napier www.manning-napier.com Unless otherwise noted, all figures are based in USD. 1 of 7
Introduction Conventional wisdom is to check the oil in your car at regular intervals. While there has been some debate as to how often to change it, there is no arguing that your car s engine couldn t run for very long without oil. However, to say that the purpose of oil is to keep the engine running smoothly doesn t give it enough credit for all of the roles it plays. Preventing the wear of the engine is a crucial role; however, engine oil also acts as a coolant, removes buildup of deposits in the engine, and can improve gas mileage. Engine oil is just as much about improving performance and efficiency as it is about preventing the engine from seizing up. For most investors, having a portion of assets allocated to fixed income is as crucial as oil is to the internal combustion engine. And similarly, there is a tendency to see fixed income as playing a single role in the portfolio when, in reality, it must fulfill several. For most investors, devoting a portion of their total portfolio to assets that may provide stability (i.e., bonds) is an important part of portfolio construction and risk management. However, the bond portion of the portfolio must also contribute towards long term goals, such as portfolio growth and generating income in order to support ongoing withdrawals. Investors are concerned not only with stability of bonds, but with their total return. As a result, the absolute level of bond yields and the potential for changes in price matter. Over the last several years, utilizing a bond index fund to gain market exposure to the broad fixed income market has become a more prevalent strategy. It is important to consider whether an indexing approach can meet the multiple demands that investors require from their allocation to bonds. There are several aspects to consider. The construction of a bond index has implications for which sectors of the market will be included, and in what amounts. In response, other characteristics of the index will change, such as its overall interest rate sensitivity. In the current low interest rate environment, the present makeup of the index may offer little in terms of yield potential or capital appreciation, and an increased proportion to U.S. government securities may make the index more sensitive to rising rates than it has been in past years. In such an environment, active bond managers may be able to better identify opportunities in fixed income in the interest of meeting the multiple goals of a bond portfolio. Bond Index Basic Characteristics Broad fixed income benchmarks such as the Barclays U.S. Aggregate Bond Index 1 (BAB Index) provide investors with exposure to the U.S. investment grade taxable bond market, primarily U.S. government-related bonds, mortgages, and corporates. Given that this index provides wide coverage of the bond market, it has become a common index to track for bond index funds. Similar to many broad equity indexes, the BAB Index is market-capitalization weighted according to the total value of the outstanding bonds in the market. Bond issuance is the driving force which determines the composition of the market and how it will change over time. As new bonds enter the market, and older bonds reach maturity, the overall makeup of the market and the balance between various fixed income market sectors can shift significantly. Because issuance drives index allocations rather than a bond s fundamental characteristics, higher weighted sectors in the index may not necessarily be the more attractive sectors to fixed income investors from a yield and total return perspective. Additionally, some sectors may be emphasized more than others on average over time. For a more in depth discussion of risk management implications of bond index construction and a brief history of the changes market composition over time, please see the Appendix. Ultimately, future bond returns will be highly dependent both on absolute interest rate levels at the beginning of a period and changes in yields over the entire investment timeframe. As the environment changes, the compensation for taking on various risks (i.e., interest rate risk or credit risk) can change. Investors should take into account whether the most highly weighted segments of the Index are adequately compensating them for their risks, given yield levels or through prospects for capital appreciation. An increase in bond supply may not always be accompanied by attractive prospects for yield and total return. For example, Chart 1 on the following page shows that while the corporate bond sector underperformed in 2008 relative to the BAB Index as a whole, the sector has performed well on a relative basis over the last six years. Over the same time period, the Index has had comparatively higher weights to government-related and mortgage-backed securities, which underperformed corporate securities. 2 of 7
Chart 1: Cumulative Excess Returns Relative to BAB Index Over Market Cycle 15% 10% 5% 0% -5% -10% -15% -20% Source: Morningstar Treasury 4 Mortgage 2 Corporate 3 In the current environment, certain characteristics of the BAB Index may represent a challenge to investors. Specifically, higher allocations to Treasuries along with more elevated sensitivity to interest rate movements may limit the total return potential of the Index going forward. Additionally, the current composition of the Index may provide fewer opportunities for yield compared to a more flexible bond investing approach. Current Yield Levels Bond starting yields have historically provided an indication of potential returns going forward. When yields begin at higher levels, the bond will yield a higher interest payment (coupon) through maturity, one of two important components of a bond s total return. Given that current yields are at historical lows, coupon payments on bonds may be limited going forward. Chart 2 below illustrates the long term broad trend down in interest rates since the 1980s, with current yields at approximately 2.2%. Chart 2: 10 Year Treasury Yield 20.00% 16.00% 12.00% 8.00% 4.00% 0.00% 6/1/2003 2/1/2004 10/1/2004 6/1/2005 2/1/2006 10/1/2006 6/1/2007 2/1/2008 10/1/2008 6/1/2009 2/1/2010 10/1/2010 6/1/2011 2/1/2012 10/1/2012 6/1/2013 2/1/2014 10/1/2014 4/1/1953 10/1/1955 4/1/1958 10/1/1960 4/1/1963 10/1/1965 4/1/1968 10/1/1970 4/1/1973 10/1/1975 4/1/1978 10/1/1980 4/1/1983 10/1/1985 4/1/1988 10/1/1990 4/1/1993 10/1/1995 4/1/1998 10/1/2000 4/1/2003 10/1/2005 4/1/2008 10/1/2010 4/1/2013 Source: Federal Reserve The other important component, the bond s change in price over the period, is inversely related to changes in yields over the investment timeframe. Accordingly, in periods of falling interest rates, the price of bonds will rise and in rising rate environments, prices will fall. These two scenarios may affect whether the total return of a bond is above or below its coupon. While it can be difficult to predict moves in interest rates over short-term timeframes, the low absolute level of interest rates today appear to limit the degree to which rates can fall, while in the case that rates rise, there could be meaningful price declines. If in one year the 10-year Treasury yield is......the total return will be approximately: 0.00% 22.10% 0.50% 17.24% 1.00% 12.60% 2.00% 3.93% 2.21%* 2.21% 2.50% -0.11% 3.00% -3.98% 3.50% -7.68% 4.00% -11.21% 4.50% -14.58% 5.00% -17.81% *Current yield levels as of 12/31/2014 Source: Federal Reserve Index Government Bond Exposure Treasury issuance has been strong over the last seven years and, as a result, Treasuries have come to represent a greater proportion of the broad U.S. investment grade market. As Treasuries tend to be more interest rate sensitive than mortgage and corporate securities, the overall interest rate sensitivity of broad U.S. bond indexes has also risen in recent years. A portfolio s duration is used to measure the overall sensitivity to changes in interest rates and can be expressed as the average number of years until the bondholder is repaid. In recent years, the duration of the Aggregate Bond Index 5 has become more elevated, to 5.3 years as of the end of 2014. To the extent that interest rates begin to rise, the heightened allocation to Treasuries may create an additional performance headwind for investors using bond indexing strategies. Chart 3 on the following page shows the percentage of the Aggregate Bond Index made up of U.S. Treasuries and the effective duration of the Index. As a result of increasing issuance, the Index has an allocation of approximately 36% to Treasuries as of 12/31/2014. 3 of 7
Chart 3: Aggregate Bond Index 5 Treasury Allocation and Duration Treasury Allocation 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Source: BondEdge 12/31/2007 6/30/2008 12/31/2008 6/30/2009 12/31/2009 6/30/2010 12/31/2010 6/30/2011 12/31/2011 6/30/2012 12/31/2012 6/30/2013 12/31/2013 6/30/2014 12/31/2014 The reality is that all broad fixed income sectors are likely to face headwinds of low yields and the potential for rising rates; however, some sectors such as corporate bonds may offer more potential for yield compared to Treasuries, or may be less sensitive to broad interest rate movements. The performance of corporate bonds relative to Treasuries depends on the amount of additional yield offered ( spread to Treasuries) and how this spread changes over time. Additional yield offered by corporate bonds can help to mitigate low overall fixed income yields, while also providing some dampening of price declines to the extent that rates rise. When determining whether corporate bonds are attractive relative to Treasuries, a key consideration is the financial health of corporate issuers, as spreads to Treasuries generally widen as corporate profits and financial strength deteriorates, and tighten as these characteristics improve. Chart 4: Corporate Bond Spreads to Treasuries 3 Source: FactSet 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Duration While spreads have narrowed significantly since the Credit Crisis, corporate America remains relatively healthy and sector fundamentals suggest that corporate bonds continue to represent an attractive investment in a low yield environment. Other spread sectors may also present opportunities to active fixed income managers, such as non-agency mortgage backed securities and asset-backed securities, which have both experienced a strong recovery and improvement in credit quality since the Credit Crisis. Active Management and the Environment Historically, both active and passive fixed income approaches have experienced periods of relative success versus each other, and environmental factors have often played a role in determining how active managers perform relative to the benchmark. The BAB Index has typically performed better than the average active bond manager in certain environments, such as 2008 and 2011 where the Index s higher weighting to Treasuries and governmentissued mortgages has been an advantage at a time when investors are seeking safety from equity volatility. That said, active managers have often shown skill in identifying undervalued securities in a diverse range of fixed income sectors, both within and outside the benchmark. While it is not expected that active managers will outperform in all environments, managers who were able to successfully navigate the interest rate and credit volatility of 2008, and take advantage of attractively valued spread sectors of the market in subsequent years, have generally been better able to generate an attractive total return versus the BAB Index over a full market cycle. Given today s environment, a passive approach that follows the benchmark may be limited in terms of yield and total return. In contrast, an active investment approach may be able to manage market risks and identify opportunities across all areas of the fixed income markets. 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 1/1/2000 11/1/2000 9/1/2001 7/1/2002 5/1/2003 3/1/2004 1/1/2005 11/1/2005 9/1/2006 7/1/2007 5/1/2008 3/1/2009 1/1/2010 11/1/2010 9/1/2011 7/1/2012 5/1/2013 3/1/2014 4 of 7
Conclusion Index-based fixed income strategies may provide investors with exposure to a broad range of investment-grade securities; however, the current composition of the BAB Index may be a source of potential risks in today s market environment. Most notably, the benchmark s increasing allocation to U.S. Treasury securities could represent a performance headwind in light of current low yield levels and the general sensitivity of Treasury prices to rising interest rates. With an investment strategy based on the benchmark, a passive approach would be restricted to this current composition of the Index. In contrast, given the dynamic nature of fixed income markets, an active strategy allows for the ability to adjust to changing market conditions. More specifically, active management provides the flexibility to adjust a portfolio s overall duration in response to interest rate movements, as well as allocate assets to the most attractive fixed income sectors and securities. Most importantly, an active approach to fixed income management can also take into account an investor s longterm goals, objectives, and risk tolerance in implementing the most appropriate fixed income investment strategy. Past performance does not guarantee future results. Unless otherwise noted, index returns provided by Morningstar. Analysis by Manning & Napier. Morningstar 2015. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results. 1 The Barclays U.S. Aggregate Bond Index is an unmanaged, market-value weighted index of U.S. domestic investment-grade debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more. Index returns do not reflect any fees or expenses. 2 The Bank of America (BofA) Merrill Lynch U.S. Mortgage Master Index is an unmanaged index of U.S. residential mortgage pass-through securities issued by U.S. agencies. The index includes 30- year, 20-year, 15-year, and interest-only fixed rate mortgage pools with at least one year remaining term to maturity, and a minimum amount outstanding of at least $5 billion per generic coupon and $250 million per production year within each generic coupon. The Index is denominated in U.S. dollars. 3 The Bank of America (BofA) Merrill Lynch U.S. Corporate Master Index is an unmanaged index of investment-grade corporate debt publicly issued in the U.S. domestic market. The securities must have at least one year remaining term to final maturity, a fixed coupon schedule, and a minimum outstanding of $250 million. The Index is denominated in U.S. dollars. 4 The Bank of America (BofA) Merrill Lynch U.S. Treasury Master Index is an unmanaged index of sovereign debt issued by the U.S. government in its domestic market. The securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion. The Index is denominated in U.S. dollars. 5 Aggregate Bond Index (Aggregate Bond) powered by BondEdge. The replicated index represents U.S. domestic investment-grade debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more. Data provided is for a replicated index and is not that of an actual industry index. 5 of 7
Appendix A: Cap Weighting for Bond Indices As was noted earlier in this paper, bond indexes are often market capitalization-weighted, which brings up several risk management considerations. The first has to do with the weight that is given to securities that have increased or declined in price, and is a universal consideration for any cap-weighted index. The second two considerations are more unique to bond indexing: Price and Weight: As is true of any cap-weighted index, securities in the index which have increased in price are increased in weight, and those that have experienced price declines will also decline in weight. From the investor s perspective, this may result in purchases of bonds that have appreciated significantly, and selling those that have depreciated. Purchasing bonds at higher prices (lower yields) may decrease the ability of the bond to compensate an investor for its risks, including interest rate and credit risk. Issuer Representation: An important implication of indexing unique to fixed income investing is that entities issuing the most debt tend to be the highest weighted in the index. Such an entity might be a single corporation, the U.S. government, or another country if the index includes non-u.s. bonds. This could represent a risk to the extent that the issuer borrows beyond its ability to repay in the future. Thus, during more difficult credit environments, entities that have issued a large amount of bonds may experience more challenges than entities with a more manageable amount of debt. While this risk is more pronounced for high yield ( junk ) issuers, it is a consideration for the investment grade market as well. Market Representation: Most aggregate bond indexes focusing on the investment grade market place a high emphasis on government, mortgage, and corporate debt securities, as these markets are extensive in the United States. However, there are other areas of the U.S. market that are developed but have little or no representation in the benchmark. For example, asset-backed securities and commercial mortgages are two important parts of the bond market that together make up a small percentage of the index, on average. Other sectors, such as non- Agency mortgage-backed securities and inflation-linked government bonds, are excluded from the BAB Index. Appendix B: Historical Context for a Changing Benchmark Many of the risks discussed in this paper on the current environment are related to the interest rate sensitivity of the benchmark and the percent of the index made up of government bonds. At other times in history, the benchmark has appeared much different. The shifts that have occurred between government, corporate, and mortgage/assetbacked securities illustrate the extent to which issuance drives benchmark composition, and how quickly its composition can change. The following is a brief history of the changes that have occurred over the last 20 years for the three broad sectors: Treasuries: As the corporate and mortgage markets were slowing during the 2008 crisis, government spending was increasing to provide support during the Great Recession. As Treasuries are a primary means of allowing for government spending, Treasury issuance increased towards the end of 2008, and issuance over 2009 was roughly double that of 2008. The increase in Treasury issuance over the last several years has meant that government bonds have come to represent a significant portion of the index. Mortgages: An increase in government-backed mortgages and other asset-backed securities in the mid-2000s coincided with an economic recovery and a real estate boom. At peak issuance in 2007, mortgage bonds originating from government agencies became more than 40% of the total U.S. fixed income market. The subsequent Credit Crisis in 2008 was particularly challenging for the housing market and new mortgage origination began to decline. Corporates: Debt levels for corporations ebb and flow as the economic cycle progresses. Two significant peaks in corporate debt occurred in 2001 and 2007 after periods of economic expansion, and after each of these years, issuance dwindled through periods of economic recovery and corporate deleveraging. However, even in peak issuance years, corporate bonds have represented the smallest sector relative to the size of the government and mortgage markets. As such, during periods where corporate bonds represent an attractive investment relative to other fixed income sectors, the amount of exposure offered by a bond index fund may not be compelling to investors. 6 of 7
The chart below highlights the proportion of issuance within each broad sector at various points in time. Bond index allocations, however, may be different from these allocations based on construction methods, included securities, and bond prices. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 2% 23% 28% 9% 38% 6% 8% 7% 26% 22% 21% 33% 39% 37% 15% 12% 13% 21% 19% 23% 39% 4% 24% 27% 6% 39% An additional aspect of the index that has changed in the last several years has to do with bonds issued by government sponsored enterprises Fannie Mae and Freddie Mac. In September of 2008, these two enterprises were placed into conservatorship with support from the U.S. Department of the Treasury. While debt issued by Fannie Mae and Freddie Mac is not guaranteed by the U.S. government to the same extent as Treasuries and other government agency debt, they are generally perceived to have an implicit government guarantee which tends to result in yields that are comparable to Treasuries or slightly higher. Thus, the conservatorship of Fannie Mae and Freddie Mac in 2008 is an additional contributing factor to the benchmark s increased exposure to government-related securities since this time. 0% 1994 2001 2007 2008 2014 Treasury Corporate Federal Agency Asset-Backed Mortgage Excludes Money Markets and Municipal Bonds Source: SIFMA 6,7 6 2015 SIFMA (Securities Industry and Financial Markets Association). 7 Due to rounding, data may not reflect actual totals. Approved CAG-PUB015 (6/15) 7 of 7