Bonds as the Ballast

After a blockbuster year for stocks and concerns about rising interest rates, some investors might be entertaining the idea of ditching their bond holdings. We've all heard the argument, "interest rates can't go much lower." Fair enough. And while interest rates have inched up since the summer of 2013, they are still close to historic lows. I can't tell you whether rates will continue their move higher by the summer, year-end, or 2016. But I can tell you that bonds play a critical role in a balanced portfolio.

It's not the sexiest asset class, but fixed income does offer important diversification benefits on top of a stable and steady income stream. 2014 is off to a rough start. With volatility on the rise, the S&P 500 Index fell about 3.5% in January. But while stocks turned south, the bond market has rallied. In the first month of the year, the Barclays U.S. Aggregate Bond Index rose 1.5%.

This serves as a bit of a reminder of the role bonds play in a portfolio. It can make a lot of sense to start thinking tactically about your fixed-income exposure. But that doesn't mean bailing on bonds altogether, or dumping your whole fixed-income allocation into bank loans. Low-cost core bond exposure is the anchor in a portfolio. With the recent spike in volatility signaling choppy waters ahead, it may not be the best time to leave the dock without an anchor.

Suitability
For core fixed-income exposure, it doesn't get much cheaper than  iShares Core Total U.S. Bond Market (AGG). This broadly diversified fund of U.S. investment-grade bonds can serve as the anchor for the fixed-income slice of investors' portfolios. The fund's index, the Barclays Aggregate Bond Index, is the generally accepted benchmark for the U.S. investment-grade bond market and includes mortgage-backed securities, Treasuries, and corporate bonds. That said, AGG isn't a one-stop shop for comprehensive fixed-income exposure. Investors should keep in mind that the fund's benchmark does not include municipal bonds, Treasury Inflation-Protected Securities, or high-yield bonds. Therefore, complementary positions will be required for investors seeking these exposures.

AGG includes bonds across all maturities, including a 22% weighting to issues with 25 years or more until maturity. Still, the portfolio's average duration as of this writing is about five years, so the fund's overall interest-rate sensitivity is fairly moderate. Like all fixed-income investments, there is interest-rate and inflation risk to consider. Investors particularly concerned with inflation risk may consider investing in inflation-protected bonds to supplement their core bond exposure.

As the securities comprising approximately 70% of its portfolio are backed by the U.S. government, the fund carries minimal credit risk (the risk of default by an issuer). Assets representing about 12% of the portfolio's value garner credit ratings below A, according to S&P and Moody's.

An aggregate fixed-income holding, such as AGG, can serve as the ballast for a broadly diversified portfolio. Those seeking to deploy AGG within an asset-allocation framework may note its low long-term correlation with domestic equities. Consider that over the trailing 10-year period, the Aggregate Index has been just 7% correlated with the S&P 500 Index. In the more recent trailing three-year period, bonds have been negatively correlated (negative 18%) with stocks. This highlights the important diversification benefits that come from a core fixed-income allocation. On this note, it's worth recalling that in 2008 when the stock market plunged 37%, the Aggregate Index posted a gain of nearly 6%.

Fundamental View
Bonds, and in particular government issues, are traditionally seen as safe havens in turbulent times. The trailing 15-year period through December 2013 has proved to be a good time to own bonds. During this period, the S&P 500 Index posted an annualized gain of about 4.6%, while the Aggregate Index returned 5.2% annualized. This was accomplished with much lower volatility; the bond index's standard deviation was only 3.5%--a fraction of the 15.5% posted by the S&P 500 during that period.

Having reached the home stretch of a decades-long secular decline in interest rates, many are concerned that inflation and rising interest rates in the years ahead could weigh on bonds. Remember that when interest rates move up, bond prices fall. While interest rates are expected to eventually move higher from their current unsustainably low levels, the timing and magnitude of interest-rate increases remain uncertain.

The latest Federal Open Market Committee statement, released on Dec. 18, 2013, indicates that rates are likely to remain low through 2014. The target range for the federal-funds rate will continue to be between 0.00% and 0.25% for the foreseeable future. In fact, the committee stated that it anticipates, based on its assessment of economic growth, labor markets, and inflation expectations, that it likely will be appropriate to maintain the current accommodative policy well past the time that the unemployment rate declines below 6.5%.

Bond markets were jarred in the summer of 2013 when the Federal Reserve hinted that it would begin to "taper" its monthly bond-buying program. Given its recent statements and the dovish stance of Fed chairwoman Janet Yellen, there aren't likely to be any drastic or sudden changes to monetary policy. Beginning in January, the Fed started to modestly taper the pace of its monthly asset purchases. This means it will buy $35 billion of additional agency mortgage-backed securities (down from $40 billion per month) and $40 billion of longer-term Treasuries (down from $45 billion per month). While the pace of new asset purchases is being reduced, the Fed is still adding a considerable amount to its already sizable holdings of longer-term Treasuries. This purchasing activity will continue to maintain downward pressure on longer-term interest rates.

Considering the unprecedented growth of the Fed's balance sheet during the past several years, many investors have speculated about the threat of rising inflation. However, projected inflation continues to run well below the Fed's 2% long-term goal, and the Fed appears to be more focused on staving off a bout of deflation given the slack in the economy and the precipitous decline in the velocity of money.

All things considered, investors need not panic and abandon their fixed-income positions. AGG currently offers a yield to maturity of 2.32%, which will inch higher as rates increase and new higher-yielding issues are added. Moreover, it provides diversification benefits that improve a portfolio's risk/return profile thanks to its lack of (or negative) correlation with equities. Investors may need to adjust their return expectations for bonds following an excellent run for the asset class, but bonds will continue to be an important part of a well-diversified portfolio.

 

Portfolio Construction
AGG is designed to replicate the performance of the Aggregate Index and does not make active bets relative to sectors, yield curve, duration, or credit quality. The fund employs a sampling strategy to track the benchmark in order to maintain adequate liquidity and facilitate efficient trading. It currently holds more than 2,000 bonds, whereas the benchmark contains about 9,000. The index, which is a proxy for the broad, investment-grade U.S. bond market, consists of a broadly diversified selection of U.S. Treasuries, mortgage-backed securities, agencies, and corporate bonds. Liquidity constraints are balanced against transaction costs and tax efficiency in an attempt to track closely the performance of the underlying index. The fund is rebalanced monthly to adjust for the changes in the benchmark's composition and characteristics. Because the fund may have small amounts of cash at any given time, management may minimize its effects on the portfolio by investing in bond futures. The largest sector weightings are U.S. government bonds (43%), mortgage-backed securities (27%), and investment-grade corporate bonds (21%). The fund's portfolio securities have an average credit rating of A, according to S&P. Its effective duration is 5.13 years.

Fees
This fund charges a rock-bottom 0.08% expense ratio. With an estimated holding cost of just 0.13%, AGG has done an excellent job executing its sampling strategy and tightly tracking its benchmark.

Alternatives
The largest exchange-traded fund in the category is  Vanguard Total Bond Market ETF (BND), which tracks a float-adjusted version of the same benchmark and has an expense ratio of 0.10%. As a separate share class of  Vanguard Total Bond Market Index (VBTLX), this ETF can benefit from greater efficiency in the creation and redemption process (less-liquid securities can be added to the portfolio with assets from new subscriptions in the index mutual fund). Vanguard's unique structure is an important advantage in fixed-income markets in particular, where spreads are wider and liquidity is less robust. Despite its slightly higher fee, BND's estimated holding cost of 0.11% is slightly lower than AGG's.

Another alternative that tracks the same benchmark is  SPDR Barclays Aggregate Bond (LAG). This fund is considerably smaller and trades far less frequently than AGG and BND. It is also more expensive, as it levies an expense ratio of 0.16%. Something else to keep in mind is that LAG currently uses a sample of about 1,300 bonds to track the benchmark, much less than AGG and BND. This could potentially lead to greater tracking error. Recently, it has paid off; LAG's estimated holding cost of 0.06% is the lowest of the bunch. There can be no assurance that this will persist.

The low-cost leader of the group is  Schwab U.S. Aggregate Bond ETF (SCHZ), which charges an expense ratio of just 0.05%. It also tracks the Aggregate Index and currently holds a sample of nearly 1,300 holdings. Despite its smaller size and lower trading volume, SCHZ has also done an excellent job tracking the benchmark. It had an estimated holding cost of 0.11%.

Investors looking to outperform the benchmark might consider  PIMCO Total Return ETF (BOND), which follows the same strategy as  PIMCO Total Return (PTTRX) and is managed by Bill Gross. This actively managed fund charges a competitive fee of 0.55% and has outperformed the index by 0.84% during the past year. Unlike its passive peers, BOND has the ability to adjust its exposure to credit risk and interest-rate risk as Gross and his team at PIMCO see fit.

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