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The Hidden Risks of Bond Benchmarks

Key Points
  • The average duration of the Bloomberg Barclays U.S. Aggregate Bond Index has risen sharply since the end of the financial crisis and is now at its highest level on record, while average credit ratings have declined.

  • Just by tracking a benchmark bond index, investors may be unknowingly taking on more interest rate risk or credit risk than originally anticipated.

  • When investing in funds, pay attention to the underlying bonds to make sure the duration and/or credit quality matches your investing horizon and risk tolerance.

Do you rely on a mutual fund or an exchanged-traded fund (ETF) that tracks a broad bond index as part of your fixed income strategy? If so, you might want to check the underlying holdings, because your portfolio may be riskier than you realize.

We think recent changes in the bond market have eroded some of the benefits that used to come from using a broad index approach to fixed income investing. Here’s why.

Duration rising

Changes in the composition of the Bloomberg Barclays U.S. Aggregate Bond Index, which many bond investors use as a benchmark, tell the story. Over the past several years, the index's average duration has been marching higher and now matches its highest level on record. At 6.0, the index’s average duration is now up more than half a point over the past year and a half, and is well above its average of roughly 4.5 from 1989 through 2008.

This is important because duration can show how a bond’s price can be impacted by rising or falling interest rates.. All else being equal, the higher a bond’s duration, the more sensitive the bond’s price is to a given change in interest rates. The same is true for bond funds, which have an average duration based on the fund’s assets. So if you are exposed to Bloomberg Barclays U.S. Aggregate Bond Index, your holdings may have become more sensitive to interest rates without your having done anything. .

The average duration of the aggregate bond index has risen sharply over the past decade

Source: Bloomberg. Monthly data of 10/20/2017.

What does a higher duration mean in terms of prices? A simple rule of thumb when it comes to duration is that a bond's (or bond fund's) price will rise or fall 1% per year of duration for each percentage point change in interest rates for comparable maturities. In other words, given the aggregate index’s current duration of 6.0, a fund based on that index would see its price fall by roughly 6% if the relevant interest rate rose by a percentage point. That is a much larger drop than such a fund would have experienced in years past.

Why has this happened? Much of the rise in the index’s average duration is due to the rising average duration of corporate bonds in the index, primarily because corporations have been issuing so much longer-term debt to take advantage of low longer-term interest rates. As a result, the average duration of the Bloomberg Barclays U.S. Corporate Bond Index is now at 7.5, up from 6.25 a decade prior and as low as 4.5 back in 1989.

At 6.2 the average duration of the Bloomberg Barclays U.S. Treasury Bond Index hasn’t risen as much as corporate bonds, but it’s still at the high end of its range over the past three decades. And while mortgage-backed securities’ average duration is above the long-term average, it is still below the recent peak hit in 2013.

Average duration in the corporate bond market is much higher than other parts of the bond market

Source: Bloomberg, using monthly data as of 10/20/2017. Indices represented are the Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, and the Bloomberg Barclays U.S. MBS Index.

Credit quality is also declining

Unfortunately, rising interest rate risk isn’t the only issue here. Average credit quality has been modestly declining, as well. While highly rated securities still occupy a big share of the Bloomberg Barclays U.S. Aggregate Bond Index—after all, U.S. Treasuries still make up 37% of the index—the share of securities with ratings at the lower end of the investment grade spectrum has been growing. As the chart below illustrates, those bonds with single-A and triple-B ratings now make up a quarter of the index, up from just 16% a decade ago.

The share of lower-rated bonds on the aggregate index has been rising

Source: Bloomberg.

The decline in average corporate bond ratings is the main culprit here. Prior to the financial crisis, there were many more highly rated corporate bond issuers—those rated AAA or AA—than there are today. Many issuers were downgraded after the crisis and still really haven’t recovered those higher ratings.

As you can see, the average credit rating of the Bloomberg Barclays U.S. Corporate Bond Index has shifted sharply lower. A decade ago, roughly 27% of the index was composed of the highest-rated corporate issuers, but today they make up just 11%. Looking at it another way, those bonds with the lowest investment grade ratings of A and BBB make up 88% of the index today.

The share of lower-rated bonds on the corporate index has been rising

Source: Bloomberg.

Investing in an index fund that tracks the broad corporate bond market may mean unknowingly investing in bonds that have credit ratings that may be too low for your risk profile. While we still consider investment grade corporate bonds as “core” fixed income holdings, not all investment grade corporate bonds are created equal. The chart below demonstrates that bonds with a rating of BBB have defaulted more frequently than those with higher ratings and therefore have more credit risk.

Lower-rated bonds have historically defaulted at higher rates

Source: Schwab Center for Financial Research with data from Standard & Poor’s 2016 Global Corporate Default Study. The study analyzed the rating and default history of 18,979 U.S. and non-U.S. companies first rated by Standard & Poor’s between 12/31/1980 and 12/31/2016. 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.

What to do now

By investing in funds that are meant to track a common bond benchmark, investors may be taking on more interest rate risk or more credit risk than initially anticipated. Bond benchmarks can be a good guideline when it comes to finding the right fixed income investments, but they shouldn’t necessarily dictate investment decisions.

Investors may look to diversify their fixed income portfolios away from common benchmark indices, identifying investments and strategies that may better meet their investing needs. That may mean investments that track more specific benchmarks—like those that specifically target an intermediate maturity range or average credit rating, for example.

For fixed income investors today, we prefer an average duration in the three- to seven-year range. This represents the steepest part of the Treasury curve, but it also helps limit interest rate risk compared to bonds with longer maturities. While the average duration of the Bloomberg Barclays U.S. Aggregate Bond Index technically fits in that range, it’s on the high end and rising. Meanwhile, the average duration of the corporate bond index is completely out of that range.

How can investors get the duration exposure we prefer? First, it makes sense to look at what the average duration of a given fund is. That can be found when researching funds on schwab.com by clicking the “Portfolio” tab. The average duration of the fund will be listed on the bottom.

To lower the average duration of your fixed income holdings, you can still focus on funds that track the aggregate bond index, but consider balancing them with some short-term investments. You can achieve an “average” duration in the three- to seven-year range by holding a mix of shorter- and longer-duration funds. Adding short-term funds can help lower the overall duration of your holdings, while also helping to provide liquidity for more short-term needs.

Investors can also find information about the average credit quality of each fund’s holdings under the “Portfolio” tab on schwab.com. Given the deteriorating trend in corporate bond credit ratings, it’s worth paying attention to a fund’s underlying holdings and making sure the average credit rating of a given investment matches your risk tolerance.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

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. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.

Bloomberg Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if 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.

Bloomberg Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity.

Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index is a market value-weighted index that measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Freddie Mac (FHLMC). It includes securities that have 30-, 20-, 15-year and balloon securities with remaining maturity of at least one year and more than $250 million outstanding face value.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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