Portolio Manager Perspectives: The Hidden Risk of Bond Indexing

October 3, 2012

Key Takeaways:
    1. We believe US Treasury and other US Government securities are overvalued today.

    2. Investors buying bond index funds have significant exposure to overvalued US government securities.
    3. US Government issues represent 72% of the Barclays Capital Aggregate Index, a widely followed bond Index
      (Treasuries 36%, agency debentures 5% and agency mortgages 31%).
    4. Better value can be found in other non-government sectors.

US Government Securities are Overvalued

In response to the financial crisis in 2008 and subsequent severe economic downturn, Central Banks around the world have implemented massive, untested stimulus programs. In an effort to push yields on US Treasury and government agency debt to historic lows, the Federal Reserve has implemented massive purchase programs in the government debt markets. This included two rounds of what was called “quantitative easing,” sometimes referred to simply as “QE1 and QE2.” “Operation Twist” in which the Fed purchases longer-term maturity U.S. Treasury securities while selling shorter maturities has led to additional Fed intervention in the U.S. Government sectors of the bond market. Most recently in September, the Fed announced a third round of quantitative easing, “QE3,” in which they will be purchasing $40 billion/month of U.S. Agency mortgage-backed securities. Further, the Fed has pledged to keep short-term interest rates near zero through mid-2015.

This new and untested direct bond market intervention in the U.S. Government securities market by the Fed has likely helped the US economic recovery on the margin but has also driven US Government bond prices higher to levels that we believe are overvalued..

The government is not the only buyer. Institutional and foreign buyers, seeking a safe haven, have piled into Treasuries, further driving down yields. Today nominal yields on Treasuries with 10 year maturities and shorter are less than the current and expected rate of inflation which means they have negative real yields.

Bond Indices are Dominated by US Treasuries and US. Government Issues

We believe bond index investors are overly invested in U.S. Government issues. Bond index funds, mirroring the index, invest a significant portion of their assets in US Treasuries and government agencies which we believe are the most expensive among all of the fixed income investments in the market. US Treasuries represent 36% of Barclay’s Capital Aggregate Index, and US Government issues represent 72% of the Index (Treasuries 36%, agency debentures 5% and agency mortgages 31%).

By indexing, investors are locked into investing the majority of their portfolio in sectors of the bond market in which the Fed is actively buying and manipulating prices higher. With government issues trading at historically low yields, the yield to maturity on the Barclays Capital Aggregate Index is just 1.72% meaning index investors earn very little yield and income.

Better Value Can Be Found In Other Sectors of the Bond Market

Without taking significant incremental risk, bond investors can find more attractive value in other sectors of the bond markets.

Right now, we favor a diversified portfolio of investment grade bonds broadly diversified across sectors with an overweight currently to high quality corporate bonds. We have also found opportunities on a selective basis in non-agency residential mortgage-backed securities and commercial mortgage-backed securities. For some investors, limited exposure to non-investment grade bonds on a well diversified basis can make sense. Here we suggest limited exposure to well-researched companies with more stable financial positions relative to other non-investment grade issuers.

This sector allocation strategy can provide a significant yield advantage versus the Barclays Aggregate Bond Index.

Suggested Alternative Strategies

    1. Significantly underweight US Treasuries , especially short to intermediate maturities.
    2. Overweight short and intermediate investment grade corporate bonds which offer attractive alternatives with limited
      additional risk. Diversification is the key to controlling credit risk. For many, a mutual fund may be the answer to achieving
      adequate diversification at a reasonable cost.
    3. Watch roll-down. Position bonds on steeper parts of the yield curve to capture additional total return as bonds “roll down”
      toward maturity. This additional yield can be significant.
    4. Consider higher quality mortgage and asset back securities to find additional yield and return.
    5. Avoid bond index funds – their market weighted exposure to US Government issues, especially Treasuries, severely reduces
      yield and relative return potential.
Important Disclosure Information

The Barclays Capital Aggregate Index is a widely followed bond index comprised of approximately 8,000 publicly traded bonds, including US Government, mortgage-backed and corporate bonds with an average maturity of approximately 7 years.

Yield curve roll-down is an additional price return component of a bond simply due to the passage of time. As a bond’s time to maturity shortens with the passage of time it will be valued at a lower yield/higher price given its now shorter maturity assuming a normal upward sloping yield curve which exists today.

The suggested alternative strategies may help protect principal in a rising interest rate environment and allow an investor to capture higher yields. There are risks involved with this strategy including, but not limited to, changes in interest rates, liquidity, credit quality, volatility and duration.

Investments in mortgage and asset-backed securities include interest rate, prepayment and default risks.. Investments in non-investment grade debt securities include risks such as increased credit risk and higher risk of default or bankruptcy.

Diversification does not ensure against loss and does not guarantee a profit. Past performance is not a guarantee of future results.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus and application, contact Baird Funds directly at 800-444-9102 or contact your Baird Financial Advisor. Please read the prospectus or summary prospectus carefully before investing.

 

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