Going Light on Treasuries for a Heavier Yield

Responding to the financial crisis, the U.S. Federal Reserve lowered the federal-funds rate to near zero in 2008. Around that time, the Treasury Department started issuing a record amount of bonds to address long-term Medicare and Social Security expenses while taking advantage of low interest rates. As a result, Treasuries' share of the investment-grade universe climbed significantly. The market-cap-weighted Bloomberg Barclays U.S. Aggregate Bond Index, which is the most widely cited U.S. investment-grade benchmark, now has more than one third of its portfolio invested in Treasuries. Moreover, yields on U.S. Treasuries are at their near-historic low, and it is quite telling that the 30-year Treasury yielded 3% as of June 11, 2018. Consequently, funds tracking that index have delivered low returns.

However, this additional yield is not free. It comes with greater credit risk and often slightly greater interest-rate risk. This trait, coupled with the fund's relatively short record, limits the strategy to a Morningstar Analyst Rating of Bronze.

The fund's benchmark, the Bloomberg Barclays U.S. Aggregate Enhanced Yield Index, divides the investment-grade-focused Aggregate Index into 20 subcomponents. These are defined by sector (securitized, corporate credit, and government), maturity, and credit rating. Each month, the fund reweights these subsectors to maximize the portfolio's yield under a set of constraints to limit turnover, preserve diversification, and limit risk. Compared with the Aggregate Index, the reconstructed index's subsectors can only deviate up to 20%, and its monthly tracking error relative to the original index is capped at 0.35%.

While the fund does take greater credit risk than its parent benchmark, this risk is still moderate and is more representative of how active managers in its Morningstar Category invest. The fund currently allocates roughly half of its assets to corporate bonds (20 percentage points more than the Aggregate Index), about 30% to securitized products, and the balance to Treasury securities. The Aggregate Index's Treasuries exposure is around 40%. The portfolio's duration of 6.9 years is about one year longer than the Aggregate Index's. Also, this fund's tilt toward credit enables it to offer a higher yield.

The strategy's record is short. From its July 2015 inception through May 2018, the fund trailed the benchmark by 0.20%. This gap is on par with the expense ratio of 0.12%. However, the fee waiver of 0.08% is set to expire in December 2018.

Fundamental View Though there is a strong argument to be made for investing in a broad market-cap-weighted bond index, the approach does have drawbacks. One of the biggest drawbacks is that issuers' financing activities have a significant impact on the composition of the universe. In the investment-grade bond market, the U.S. government has issued a record amount of debt. In 2012, the Treasury Department started issuing longer-term bonds to address long-term Medicare and Social Security expenses while taking advantage of low interest rates. As a result, Treasury securities make up approximately 40% of the broad market-cap-weighted Aggregate Index, limiting its return potential.

To increase its return, the portfolio reweights the components of the Aggregate Index to emphasize the higher-yielding areas of the investment-grade market. This dynamic approach allows the fund to shift its sector exposure (credit, securitized, and government) as sector fundamentals and investor appetites evolve. The portfolio has a few constraints to keep it diversified and prevent it from taking too much risk. These include limiting tracking error to the Aggregate Index, keeping the subcomponent weightings within 20% of the parent index, and limiting duration to no more than one year longer than that benchmark.

Although the investment universe is confined to investment-grade bonds, the process does increase the portfolio's credit risk. The fund is permitted to add up to 20% more securities rated BBB than its parent index. This rating is the lowest credit rating for an investment-grade bond, and the portfolio's BBB exposure was about a fourth of its assets--5 percentage points more than the intermediate-term bond category average and 10 percentage points more than the Aggregate Index.

In addition, the fund's interest-rate risk profile is likely to move in tandem with the broad market-cap-weighted index thanks to its duration variation cap of one year against the Aggregate Index. The strategy had a duration of 6.9 years compared with the category average of 5.9 years as of May 2018.

This strategy is not completely free from the broad market composition, since it constrains its portfolio against the Aggregate Index. For example, within the portfolio's corporate-bond sector, financial firms are the largest holdings. This is because there have been active issuances by U.S. financial institutions in recent years. During 2016 alone, U.S. financial firms issued $299 billion of debt, pushing the sector's total outstanding debt to $1.6 trillion as of December 2016, according to Fitch. The issuances were largely driven by low rates and post-crisis regulatory changes.

Despite its short history, this fund has produced a decent performance. From its July 2015 inception through May 2018, its annual return was 2.1%, which bested its category peer average. On a risk-adjusted basis, as measured by Sharpe ratio, it ranked in the top third of the category during that period.

Portfolio Construction The fund employs representative sampling to track the Bloomberg Barclays U.S. Aggregate Enhanced Yield Index. This broad portfolio is arguably more representative of how active managers in the category invest than the market-cap-weighted Bloomberg Barclays U.S. Aggregate Bond Index. It takes reasonable steps to boost yield without taking excessive risk and to keep turnover under control. It warrants a Positive Process Pillar rating.

This strategy divides the Aggregate Index into 20 subcomponents based on different risk dimensions, including sector exposure, interest-rate risk, and credit risk. In total, six of these buckets cover Treasury and agency debt, nine cover corporate debt, and five cover securitized debt. It then reweights them to maximize yield under a set of constraints. These include limiting tracking error relative to the Aggregate Index, keeping sector weightings within 20% of that index, and preventing duration from extending beyond a year longer than the index. It also limits turnover each month. Eligible securities include U.S.-dollar-denominated investment-grade bonds with at least $300 million in par outstanding. Asset-backed and commercial mortgage-backed bonds have different liquidity requirements. Yield to worst is the primary measure for calculating expected yields.

Fees The fund has an expense ratio of 0.12%, net of a 0.08% fee waiver, which gives the strategy a durable edge and supports the Positive Price Pillar rating. In fact, this fund is cheaper than 95% of its intermediate-term bond category peers and is lower than the 0.80% category average fee. The 0.08% fee waiver is set to expire at the end of 2018. That would increase the expense ratio to 0.20%, which would still put the strategy in the category's cheapest decile. During the past year, the fund has lagged its benchmark by 20 basis points, slightly more than the amount of its expense ratio.

Alternatives

There are several Silver-rated, low-cost funds that track the market-cap-weighted Bloomberg Barclays U.S. Aggregate Bond Index. Accordingly, the composition of this index is heavier in Treasuries than AGGY's. These funds include

Silver-rated

Silver-rated

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