- Given the dominance of the Aggregate Index as a fixed-income benchmark, it is more important than ever for investors to understand its composition.
- We examine the transformation in the Aggregate Index over the past decade and explain how the interplay between the mortgage, corporate and US Treasury sectors has resulted in a lower than expected duration extension relative to the move lower in interest rates.
- The changes to the Aggregate Index since the onset of the financial crisis have created opportunities to add value through an actively managed approach.
A longstanding pension client recently asked Western Asset to help them prepare for a Board presentation. This client, alongside many other institutional investors and $1 trillion in mutual funds and exchange-traded funds (ETFs), measures its fixed-income performance against the Bloomberg Barclays U.S. Aggregate Index (Aggregate Index). Accordingly, our analysis included a calculation of how many months it would take for the Aggregate Index to recover from a 200 basis point rise in rates.
We had previously performed this calculation for the client in 2014. While reviewing the analysis together, we noted that this year’s results were almost identical to those from 2014, in spite of the dramatic move lower in the 10-year Treasury that had occurred in the interim. The rally in rates over the past two years should have lengthened the duration of the Aggregate Index, but in fact it had hardly changed at all.
In exploring this issue with the client, we assembled some interesting findings about how the Aggregate Index has evolved since the onset of the financial crisis. Given the dominance of the Aggregate Index as a fixed-income benchmark, it is more important than ever for investors to understand its makeup. Below, we summarize recent trends in the Aggregate Index and discuss how to navigate the resultant issues.
- The Aggregate Index is comprised of USD-denominated, investment-grade and fixed-rate fixed-income assets, including US Treasuries (UST), government-related and corporate securities, mort- gage-backed securities (MBS) and asset-backed securities.1 Over the past 10 years, the composition of the Aggregate Index has shifted away from mortgage-backed securities and toward USTs and corporate bonds. The MBS component peaked at 41% at the end of October 2008, and since then has steadily declined to its current level of 28%. This decline was due not to a decrease in the market value of the MBS sector, which has treaded water, but rather to an increase in the market value of the government and corporate sectors, whose combined market share has ballooned from 51% to 65% over the same time period (Exhibit 1). Notably, the Aggregate Index does not exclude agency MBS held by the Federal Reserve (Fed). Were the securities purchased by the Fed to be excluded, the decline in MBS market share would be even more dramatic, with the MBS component dropping to just 20%.2
- As would be expected with the move down in yields, the duration of the Aggregate Index has drifted upward over the last decade. Bonds with lower coupons are more sensitive to changes in interest rates, and therefore have longer model durations than do bonds with higher coupons. Because more of the present value for lower coupon bonds comes from the principal or bullet payment which occurs further out in time, their prices are more reactive to interest rate movements.
As rates have moved lower, the Aggregate Index has extended less than one might have expected, however, due to two countervailing trends. First, corporate and government issuers have moved out the curve to take advantage of attractive long-term funding. The percent of the Aggregate Index composed of corporate and government bonds with maturities of at least 10 years has steadily increased over time, as has the duration of such bonds (Exhibit 2). This has resulted in an increase in the duration contribution coming from corporate and government bonds in both absolute and relative terms (Exhibits 3 and 4).
Second, MBS durations have contracted since 20133 as USTs have rallied. Primary mortgage rates moved lower with UST yields, increasing the incentive for homeowners to refinance into lower rates. Model MBS durations shortened to reflect this increased callability. As a side note, Bloomberg Barclays’ MBS durations have contracted over this time period to converge with another widely used model, Citigroup Yield Book (Exhibit 5). The relatively accelerated contraction in Bloomberg Barclays’ MBS durations has resulted in a shorter broad market index for Bloomberg Barclays relative to Citigroup (Exhibit 6).
- Large scale asset purchase programs and low to negative central bank rates have compressed yields across the globe. These forces have not spared the yield of the Aggregate Index, particularly as the market share of USTs in the Aggregate Index has increased. The spread of non-Treasury sectors in the Aggregate Index, however, has served as an offset. A simple analysis calculating the rate move that the Aggregate Index could sustain given its yield cushion indicates that valuations are in line with historical relationships, with the current breakeven rate move as a percent of the 10-year Treasury yield right around its 10-year average at 23% (Exhibit 7).
Whether they have passive or active exposure to the Aggregate Index, investors must thoroughly understand what the benchmark represents in order to ensure their portfolios are addressing their investment goals. We believe that the changes to the Aggregate Index since the onset of the financial crisis have created opportunities to add value through an actively managed approach.
Based on its macroeconomic outlook, a skilled active manager can generate excess return by shortening or lengthening duration versus the benchmark, as well as choosing where along the yield curve to take such positions. Given the changes in duration that have occurred over the Treasury bull market and their effect on the risk profile of the Aggregate Index, the role of active duration management in the portfolio management toolkit has grown even more essential.
Today’s Aggregate Index is not only longer in duration but also contains a higher proportion of longer maturity bonds than in years past. It represents a greater concentration of corporate and Treasury issuance as well. Because of these factors, the ability to assess fundamental value takes on heightened importance.
Some of the best investments both today and historically have been in opportunistic sectors that are not eligible for inclusion in the Aggregate Index, for example, non-agency MBS, emerging market, high-yield and global debt. An active approach is a potent way to invest in the broad fixed-income universe, particularly in the present regime where sovereign valuations have been distorted by technical factors. The ability to access sectors outside the benchmark can provide active managers with a distinct advantage over the Aggregate Index.
- Please see https://index.barcap.com/Home/Guides_and_Factsheets for the requirements for inclusion in the Bloomberg Barclays U.S. Aggregate Index.
- As of 8/31/16 per the Bloomberg Barclays U.S. Aggregate Float Adjusted Index, which excludes fixed-rate agency MBS and agency bonds held by the Federal Reserve. Both the Bloomberg Barclays U.S. Aggregate Index and the Bloomberg Barclays U.S. Aggregate Float Adjusted Index reduce the Treasury amounts outstanding by the Federal Reserve’s SOMA holdings.
- MBS durations rose during 2012 and 2013 due in part to the success of the Home Affordable Refinance Program, or HARP, streamline refinance program. This program enabled homeowners with loan-to-value ratios exceeding 80% to easily refinance, which resulted in a lower coupon profile for the MBS universe. The incentive to refinance for these borrowers as well as new homeowners who borrowed at lower rates was minimal, as reflected in their longer durations.