Executive Summary
The Bloomberg Barclays U.S. Aggregate index, aka the “Agg,” is taking an aggressive stance on risk. While it seems counterintuitive to claim that a passive instrument is taking an aggressive stance on anything, that is the nature of bond indexes, by design. We believe they are fundamentally flawed in their construction. Today is a prime example. The Agg has been loading up on lower credit quality bonds at what looks to be the wrong point in the credit cycle, and it has been extending duration at some of the lowest yields in U.S. history. In other words, this passive aggressive index has turned prudence on its head.
It is well understood among investors that there have been massive flows out of active equity funds into passive vehicles, such as index funds and ETFs. What has not been as widely appreciated is that the same thing is happening in fixed income. Nearly 40% of all “core” bond funds today are passively managed (up from 16% only 10 years ago). One index in particular is vacuuming up these assets – the Bloomberg Barclays U.S. Aggregate Index, commonly known as “the Agg.” We think this massive movement to the Agg is ill-timed and is turning the very concept of prudence on its head because the index suffers from the following problems:
- Its construction is fundamentally flawed.
- It suffers from deteriorating corporate credit quality at a concerning point in the market cycle.
- It has been extendingduration (increasing interest rate risk) at some of the lowest yields in U.S. history.
- It offers some of the lowest expected returns in its history.
- It hovers close to 0% in real yields.
- It has been one of the worst-performing strategies in bond management universes in the last 1, 3, 5, 7, and 10 years.
We first wrote about our Agg-related concerns back in 2017, but with interest rates dipping back toward historically low levels this fall, we wanted to revisit and expand on our concerns, especially given that flows into passive have only accelerated recently. We also wanted to offer some concrete suggestions for what we believe is a better approach to fixed income investing.
The Age-Old Bums Problem
It is well understood among fixed income managers that bond indices suffer from a flawed construction. Laurence Siegel, formerly Director of Research at the Ford Foundation, named this flaw “The Bums Problem.” It aptly points out that a cap-weighted index for bonds is, by design, loading up on the most indebted issuers within its universe (note that cap-weighting makes sense in equities, but it makes no sense in bonds). This means that an index is at great risk of rotating into the wrong sectors just as these issuers are the most vulnerable. For example, in the late 90s, the Agg dramatically increased its exposure to technology and telecom bonds, just in time for the Tech Bubble bursting. From there, it loaded up on bank credit, right before the Great Financial Crisis (GFC). Finally, as shown in Exhibit 1, in 2014 the Agg dramatically increased exposure to capital-intensive energy companies, just before oil prices suffered a historic collapse. Remember, it behaves this way by design.
EXHIBIT 1: BUMPING INTO THE BUMS - YOU CAN'T MAKE THIS STUFF UP
Source: POINT
Today, the index has a different problem as it has been shifting exposure to lower rated BBB-rated debt, resulting in a secular deterioration of corporate credit quality across all sectors of the Agg. Prior to the GFC, the corporate component held roughly 32% in BBB bonds – today, that number has risen to an eye-popping 50+% (see Exhibit 2).
EXHIBIT 2: CAN YOU SAY BUMS...
Source: Bloomberg
Importantly, at the same time that corporate credit risk is going up, compensation for taking that risk is going down. Prior to the GFC, the typical spread between AAA and BBB rated bonds hovered around 200 bps. Over the last 10 years, that number dropped to roughly 150 bps, and in just the last 2 years, with spreads tightening further, it is now solidly below 100 bps (see Exhibit 3). As the worldwide hunt for yield continues, the credit sector of the Agg is taking on significantly more risk yet paying investors less for doing so. This strikes us as the very definition of imprudence.
EXHIBIT 3: TAKING MORE RISK...AND GETTING PAID LESS
Source: FRED
The sheer amount of corporate debt issuance is historic, however looking at that statistic in isolation is an incomplete assessment. Instead, the focus should be on the ability to service that debt. Yet when we take a look at an important measure of that ability, Debt to EBITDA (of investment grade issuers), the story is sobering. The cycle of Debt to EBITDA typically follows a logical pattern. During economic recoveries, as earnings (the denominator) increase and outpace debt, the ratio typically moves downward (see Exhibit 4). After the recession of 1990-91, the economy and corporate earnings started to improve, and the Debt to EBITDA ratio dropped materially. Then, in the 2000 recession, as earnings collapsed and debt (the numerator) became large relative to earnings, the ratio spiked. This logical pattern repeated in the 2008 recession. Today, however, something strange is going on. As expected, the ratio started to improve in the 2010 post-GFC recovery. In the past few years, however, it has been rising markedly – before any recession. This is odd. Debt is far outpacing earnings today, ominously raising the question as to what will happen to this ratio, already at extremes, when the next recession eventually hits?
EXHIBIT 4: WHAT ABOUT NEXT RECESSION?
Source: Morgan Stanley
Calculation was of the median investment grade issuer (excluding financials and energy).
Continue reading here.
Also check out:
