The Bloomberg Barclays US Aggregate Index, which encompasses the broad U.S. investment-grade market, is the most popular benchmark for the U.S. investment-grade market. However, its heavy emphasis on low-yielding Treasury and agency bonds makes it more conservative than most of its active peers and easy to beat. The Bloomberg Barclays US Universal Bond Index, which iShares Core Total USD Bond Market ETF (IUSB) tracks, attempts to address the concerns by including non-investment-grade corporate bonds and emerging-markets debt, boosting its yield while improving diversification. Yet, the fund still maintains considerable exposure to government-backed bonds, which account for about half of the portfolio, balancing out the increased credit risk.
IShares Core Total USD Bond Market ETF provides market-cap-weighted exposure to the broad U.S.-dollar-denominated bond market, spanning the entire credit spectrum. The fund efficiently tracks the Bloomberg Barclays US Universal Index, and it is currently the only fund replicating the index. Also, its fee is one of the lowest in the intermediate-term bond Morningstar Category. But its cap-weighting approach leads to a Treasury-heavy portfolio that does not resemble holdings of its actively managed peers. It earns a Morningstar Analyst Rating of Silver.
This fund offers exposure to a wide range of taxable, U.S.-dollar-denominated bonds with maturities of one year or longer and any credit rating. It weights these securities by market capitalization, tilting the portfolio toward investment-grade bonds. The investment-grade portion takes up more than 90% of the fund, in line with its category peers. Also, low-yielding, yet secure US Treasuries and government-sponsored enterprise mortgage-backed-securities make up roughly half of the portfolio. The category average is approximately 30%. But this fund still delivers a relatively higher yield thanks to its below investment-grade holdings.
Its bias toward highly rated securities could help mitigate the credit risks associated with high-yield holdings and preserve its value during market downturns. During the financial crisis, the fund’s underlying index gained 3.9% while the category declined by 0.4% on average. And the fund has tightly tracked its index since its June 2014 launch.
This fund has performed well in recent years due to the cost advantage. Its 3-year annualized performance from May 2015 to April 2018 was 1.4% beating its category average by 20 basis points annually. Its annualized risk-adjusted return for the same period was also slightly better than the intermediate-term bond category average.
Investing in a broad market-cap-weighted bond index, like stock indexing, has a few advantages. The indexed portfolio replicates the composition of the fixed-income market, reflecting market participants’ collective views about the value of each security for a low fee. But there are some drawbacks.
Market-cap weighting skews the portfolio toward the most heavily indebted issuers, leading to a large weighting in low-yielding government-related securities. This large weighting is not representative of how many active managers in the category invest. It occurs because the fixed-income market includes large investors who have different objectives. For example, banks often invest their reserves in U.S. Treasuries, and life insurance companies use long-term Treasury bonds to match the duration of their liabilities.
Although the fund’s duration is similar to the category average, it has considerable exposure to interest-rate risk. Its duration of 5.3 years implies that if the rate rises by 1 percentage point, in theory this fund would lose approximately 5.3% of its value. The fund’s duration can change over time because it does not impose a maximum maturity limit and weights its holdings by market capitalization.
The portfolio’s interest-rate risk is partially offset by its low credit risk. It invests the majority, more than 90%, of its assets in investment-grade bonds and the balance in high-yield securities. The split between the two ratings buckets is in line with the intermediate-term bond Morningstar Category average. U.S. government- and government-agency-guaranteed debt account for most of its high-grade allocation, representing nearly half of the portfolio. That’s about 20 percentage points larger than the category average, giving the fund a more conservative credit risk profile. Although the fund only has limited exposure to high-yield bonds, they slightly boost its yield and increase volatility. The fund’s exposure here is comparable to the intermediate-term bond category average.
The fund has been available about three years, and it has successfully tracked its benchmark and produced decent returns since its inception in June 2014. The index and the fund posted an equal annualized return of 2.1% from inception to April 2018. This performance surpassed the category mean of 1.5%. Its peak-to-valley performance, measured by max drawdown, was on par with its peers for the same period. The fund’s fee advantage and conservative portfolio should allow it to offer attractive category-relative performance over time.
The fund earns a Positive Process rating because it broadly captures its target market and weights its holdings by market capitalization, which promotes low transaction costs and tilts the portfolio toward the most liquid issues. It uses a sampling strategy to track the Bloomberg Barclays US Universal Bond Index, which measures the total U.S.-dollar-denominated, fixed-rate, taxable-bond market. The index includes investment-grade and non-investment-grade corporate, government, and securitized bonds with a maturity of one year or longer. High-yield corporate issues must have an original deal size of at least $500 million to be eligible for the fund. The index this fund tracks is also the parent index for the widely followed Bloomberg Barclays US Aggregate Bond Index. As such, constituents in the Bloomberg Barclays US Aggregate Bond Index made up more than 80% of the index. And the remaining portions were composed of high-yield corporate bonds, emerging-markets debt, and asset-backed securities, such as commercial mortgage-backed securities and residential mortgage-backed securities. Therefore, these two indexes are likely to be highly correlated. The index rebalances monthly.
The fund has an expense ratio of 0.06%, which makes it one of the lowest-cost options in the intermediate-term bond Morningstar Category, supporting the Positive Price Pillar rating. In fact, this fund is cheaper than 90% of its category peers and is substantially lower than the 0.60% category average fee. Additionally, this fund tracked its benchmark tightly. The fund matched the performance of its index net of fees from its inception in June 2014 through April 2018.
This is the only fund tracking the broad Bloomberg Barclays US Universal Bond Index. Investors looking for exposure to investment-grade bonds only can consider Schwab US Aggregate Bond ETF (SCHZ) (0.04% expense ratio), iShares Core US Aggregate Bond ETF (AGG) (0.05% expense ratio), or Vanguard Total Bond Market ETF (BND) (0.05% expense ratio). All three funds track the Bloomberg Barclays US Aggregate Bond Index. The Vanguard ETF has a separate mutual fund share class, Vanguard Total Bond Market Index (VBTLX), which carries the same expense ratio of 0.05% and has a $10,000 minimum investment requirement.
Dodge & Cox Income (DODIX) (0.43% expense ratio) is another great active fund. A veteran and well-resourced team, time-tested process, low expenses, and an impressive long-term track record support this fund’s Morningstar Analyst Rating of Gold.
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Phillip Yoo, CAIA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.