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Is the Aggregate Index Too Heavy in Treasuries?

Record Treasury issuances during the past decade have made the index more conservative than most intermediate-term bond funds.

Thomas Boccellari, 08/20/2014

In many markets, index investing is appealing because it takes a free ride on the collective efforts of active investors, offering comparable exposure at a fraction of the cost. As long as the index is representative of what active managers in the fund world are doing, it's a good bet that a low-cost index fund will beat the average manager in the category.

However, the Barclays U.S. Aggregate Bond Index has increasingly diverged from actively managed funds in the intermediate-term bond Morningstar Category during the past five years. At the beginning of 2000, funds that tracked the Aggregate Index held bonds that were similar to the category average in duration, credit quality, and performance. But that has changed during the past several years.

Following the global economic crisis, the federal government issued more debt at a more rapid pace than corporations in order to cover the growing deficit. Because the Aggregate Index weights its holdings by market capitalization, it has increasingly devoted a greater part of its portfolio to U.S. Treasuries. During the past 14 years, the percentage of U.S. Treasuries in the Aggregate Index increased to more than 40% from 16%.

Source: Morningstar Direct; Data as of July 31, 2014.

Actively managed funds in the intermediate-term bond category were not constrained in this way and did not follow suit. On average, they devote only slightly more of their portfolios to U.S. Treasury bonds than they did in 2000. As a result, the Aggregate Index's yield declined relative to the category average. 

Foreign governments, banks, and insurance companies tend to overweight Treasuries relative to the average active fund manager in the intermediate-term bond category. But they do not usually do so to generate more attractive performance. Banks hold Treasuries to meet capital requirements. Insurance companies and pension funds may use them to match the duration of their assets and liabilities and to maintain a conservative risk profile. Similarly, foreign governments finance Uncle Sam's spending spree because the U.S. dollar is the world's reserve currency, and Treasuries represent a relatively low-risk way for them to preserve capital.

Investors, on the other hand, may not find Treasuries to be the most compelling option. Currently, the yield of the 10-year Treasury is 2.4%. That's not much compensation for its interest-rate risk. Investment-grade corporate bonds are only offering a little more. The Bank of America Merrill Lynch U.S. Corporate BBB Bond Index, whose holdings have an average maturity of 10.5 years, is yielding 1.0% over the 10-year Treasury. But that extra yield can be appealing in a low-rate environment, despite the added risk.

Treasuries and government-backed bonds have historically provided poorer risk-adjusted returns (as measured by the Sharpe ratio) than investment-grade corporate bonds of similar duration. The table below shows that corporate investment-grade bonds have offered better bang for the buck over the trailing one-, three-, five-, 10- and 15-year periods.

is an ETF Analyst with Morningstar.

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