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What’s in Your “Total” Bond Fund?

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,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.

What now?

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.

2Bloomberg Barclays.

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Important Disclosures

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

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 conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, their accuracy, completeness and reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

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