Achieving diversity in a bond portfolio used to be as simple as investing in an aggregate bond-index fund. However, recent changes to the bond market have made that strategy less effective. Government-related bonds with longer durations now comprise a larger share of the market,1 and the overall credit quality of corporate bonds has declined, leaving the bond market with more credit risk and interest-rate risk than in the past.
The Bloomberg Barclays U.S. Aggregate Bond Index, for example, the benchmark for many bond funds, is not what it was before the Great Recession—for three reasons.
1. Overexposure to Treasuries
The Bloomberg Barclays U.S. Aggregate Bond Index has a significantly higher allocation to Treasuries than it did a decade ago, largely because of the flood of federal bonds in the wake of the financial crisis (see “Treasuries take over,” below).
All things being equal, Treasuries tend to offer lower yields than other investment-grade bonds; consequently, the index’s yield prospects fall as its allocation of such bonds increases.
Further complicating matters is the fact that many of those Treasuries were issued during the recent period of historically low interest rates, meaning they—and, by extension, the bond funds that track them—will decrease in value as rates rise. That’s especially true of the longer-term bonds in the index, which will be locked into those rock-bottom rates for many years to come.
2. Increased sensitivity to rising interest rates
The U.S. Treasury isn’t the only entity that issued a raft of long-term bonds during the past decade. Many companies and governments did the same to lock in low rates for an extended period—and the Bloomberg Barclays U.S. Aggregate Bond Index has become more sensitive to rising interest rates as a result. The index’s average duration, a measure of such sensitivity, rose to 6 years in June 2017, versus 4.7 during the preceding two decades.2
3. Heightened credit risk
Over the past decade, the credit quality of the corporate bonds in the Bloomberg Barclays U.S. Aggregate Bond Index has deteriorated markedly: In 2007, 63.9% were rated A or higher; by 2017, that number had fallen to 50.6% (see “Slipping grades,” below).
Of course, lower-rated bonds tend to have higher coupons, which may help counteract the overexposure to Treasuries. However, such bonds also carry a higher degree of risk.
Investors in total bond funds should ensure their holdings are still appropriate for their needs, paying close attention to the average duration in their portfolios. Remember, too, that a single mutual fund or exchange-traded fund may not provide the “total” diversification you want. The Bloomberg Barclays U.S. Aggregate Bond Index, for example, doesn’t track the entire bond universe—just investment-grade, fixed-rate U.S. securities. If you seek exposure to high-yield, emerging-market or international bonds, you’ll have to look elsewhere. Moreover, Schwab suggests a mix of bonds and/or bond funds in which a majority of holdings are of high credit quality.
1Duration measures how many years it will take for a bond’s future cash flows to cover its cost. The longer the duration, the higher the risk its price will be affected by a future change in interest rates.