The Case for Active Fixed Income

• The Agg Index was designed in the ‘80s and is based on a rule-set that has not evolved with the bond market
• The Agg is weighted towards issuers with the most debt
• The Agg is concentrated in government or government-backed bonds
• Active bond funds and ETFs have the potential to outperform passive index funds, using intentional approaches for selecting bonds or setting sector weights.

THE BEGINNING

For many investors, the Bloomberg US Aggregate Bond Index (the “AGG”) has long been a staple of their bond allocations, often considered a "set it and forget it" option. With the AGG historically representing a significant portion, if not the entirety, of their fixed income allocations, its assets under management (AUM) have soared to over $100 billion…especially in the years following the Global Financial Crisis (GFC) driven by quantitative easing (QE) and Zero-Interest Rate Policy (“ZIRP”).

However, the landscape has shifted, and the structural tailwinds that benefited bonds, driven by a prolonged decline in interest rates, have come to an end. As a result, investors are now rightly scrutinizing their bond allocations to understand the associated risks more clearly.

REVISITING THE BLOOMBERG US AGGREGATE BOND INDEX

The AGG's construction is based on rules established in the 1980s, which may no longer be as relevant or effective in today's market environment. This situation mirrors the Dow Jones Industrial Average, which weights companies based on their stock prices—a method that can be easily manipulated and is outdated in today's market. While stock price might have been a reasonable measure of a company's market cap decades ago, this is no longer the case. Yet, the entrenched nature of these early benchmarks persists, with significant amounts of money still benchmarked to them.

PERCEPTION VS. REALITY

While the AGG is often perceived as providing exposure to the entire US bond market, akin to how the S&P 500 represents the US stock market, the reality is different. While the S&P 500 captures over 80% of the total US stock market, the Bloomberg US Aggregate Index only covers about half of the total US bond market:

Notably, when one “looks under the hood”, we see that some of the most compelling parts of the fixed income universe are completely (or largely) absent from the AGG:

The reason is simple – when the AGG was launched, U.S. Treasuries, agency mortgage-backed securities (MBS) and investment-grade (IG) corporate bonds did represent a much larger portion of the bond universe.

IMPORTANCE OF CONSTRUCTION METHODOLOGY

Beyond its exclusion of certain segments of the bond universe, the AGG also allocates positions based on the amount of debt an issuer has outstanding. This approach mirrors the phenomenon seen in market-cap weighted stock indices, whereby large, passive flows lead to a greater allocation to the largest borrowers, similar to how the S&P 500 allocates more to the largest companies. While this aspect was previously overlooked by investors a decade ago, as the trend towards passive investing has accelerated, particularly in recent years, it has become a significant consideration for both equity and bond investors.

The AGG's composition has evolved significantly since 2000, primarily due to the self- reinforcing nature of its construction methodology. This evolution is evident in both increased sector concentrations and duration. These changes highlight the importance of understanding the implications of the AGG's construction on investment outcomes.

Interestingly a 2019-piece from Callan highlighted the passive duration extension within the AGG and noted: 

“Going back to 2004, the duration of the Aggregate was shorter (4.77 years versus 5.73 today), and the yield was higher (4.64% versus 2.49%). Aggregate exposure has become more interest rate-sensitive over time, and the lower yield provides less income and less of a cushion in the case of rising rates, suggesting lower return expectations going forward.”

In retrospect, Callan offered a prescient warning to bond investors as 2022 showed.

A RETURN TO ACTIVE

The goal is not to discredit the AGG as an index, but rather to underscore the growing significance and visibility of the risks associated with it, especially looking ahead.

AN ERA OF HEIGHTED RISK FACTORS

The Covid pandemic and the resulting fiscal and monetary responses have marked a new era of investing, characterized by heightened uncertainty and risks across the board. While equities have frequently reminded investors of their downside risks, bonds have often been seen as a safer bet. However, the landscape is changing, with several prominent risks for bonds emerging:

CONCLUSION

The current market environment poses challenges for investors relying solely on passive bond benchmarks for fixed income exposure. The risks of credit and duration are heightened and unlikely to diminish anytime soon. We advocate for active risk management, particularly in fixed income, given these conditions as well as the obsolete nature of the Bloomberg US Aggregate Bond Index.

The fixed income sectors that are not well represented within the broader index represent an opportunity for active managers navigate the credit ecosystem in that way that potentially leads to higher returns with lower risk – which is high in static bond allocations. Active fixed income exposure is no longer a luxury but a necessity in today's investment portfolios.

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