Balance Credit and Rate Risk With This Bond ETF

Interest-rate risk has a much bigger impact on most core investment-grade bond portfolios than anything else. It explains 88% of the Bloomberg Barclays U.S. Aggregate Bond Index’s returns over the trailing 10 years through August 2019. That’s not necessarily a problem. The payoff to interest-rate risk is counter-cyclical because rates tend to rise during economic expansions and fall during recessions (lower rates lead to higher bond prices). So, interest-rate risk can help diversify stock risk. However, investors who are looking to balance the sources of risk in their bond portfolios might consider iShares Edge U.S. Fixed Income Balanced Risk ETF FIBR. This could serve as a stand-alone core bond allocation, but it probably won’t diversify stock risk as well as an Aggregate Index tracker.

Strategy Overview This fund targets an equal risk contribution from credit and interest-rate risk. So, it takes greater credit risk than most investment-grade-focused portfolios and less interest-rate risk. While it should deliver attractive performance over the long term, it will likely underperform during economic downturns, as rates tend to fall and credit spreads tend to widen during those times.

This strategy sizes its sector allocations so they each contribute an equal amount of estimated risk to the portfolio. This is an important departure from traditional portfolio construction, where diversification is often measured by the dollar value invested in each position and sector. The trouble with this approach is more-volatile positions account for a disproportionate share of a portfolio’s risk, so the dollar allocations may not paint an accurate picture of where a portfolio’s risk is coming from.

Risk is tough to measure precisely. However, the fund uses volatility over the past 24 months as a proxy. It starts by sizing positions across five U.S. bond sectors: mortgage-backed securities, high-yield bonds rated BB, high-yield bonds rated below BB, investment-grade corporate bonds with one to five years until maturity, and investment-grade corporate bonds with five to 10 years until maturity.

Together, these sectors represent most of the U.S. credit market, though the portfolio notably excludes commercial MBS, asset-backed securities, agency debt, and noncorporate credit. BlackRock decided to exclude these sectors because they have historically delivered subpar risk-adjusted performance. There isn’t a compelling reason to expect these sectors to underperform going forward, but their exclusion shouldn’t hurt the fund’s performance over the long term.

The fund sizes its positions to target an equal contribution of risk from each of the five credit sectors it includes, subject to a minimum monthly volatility of 1% (standard deviation) in each sector. So, more-volatile sectors like high-yield bonds receive lower dollar weightings in the portfolio. This approach effectively diversifies sector risk.

The portfolio targets a 125% notional weighting across the five credit sectors. The managers can invest more than 100% of the portfolio because they use mortgage TBAs, which are forward contracts that don’t require much collateral to get exposure to the MBS sector. They can take the remaining money and invest it in other securities, effectively leveraging up the portfolio.

With these positions set, the fund measures the contribution of risk from credit spreads and rates based on data over the past 24 months. If the portfolio has more credit risk than interest-rate risk, the managers buy Treasury futures to bring those sources of risk in line. If interest-rate risk exceeds credit risk, the managers short Treasury futures, subject to a 2% floor on monthly rate volatility.

This approach effectively balances rate risk, which is a risk-off factor, with credit risk, which is a risk-on factor. That’s good for diversification in the context of this portfolio, but it’s important not to lose sight of the bigger picture. The return to credit risk is positively correlated with stocks, so there’s a danger that leaning into it can reduce the fund’s effectiveness at diversifying stock risk. This strategy has been more highly correlated with the performance of the Russell 3000 Index than the broad market-value-weighted Bloomberg Barclays U.S. Universal Index, which includes both investment-grade and high-yield debt. But it has not been very sensitive to fluctuations in the stock market, so it should still help diversify stock risk.

Performance It's a bit surprising that a complicated strategy like this is structured as an index fund. When it was first launched, the fund was actively managed, though it followed the same strategy. BlackRock codified this process in an index (in partnership with Bloomberg Barclays), which the fund began tracking in February 2018. This allows it to show back-tested performance.

This strategy has tended to be a little riskier than the Universal Index, owing to its greater credit risk. It tracks the Bloomberg Barclays U.S. Fixed Income Balanced Risk Index, which was more volatile than the Universal Index over the trailing 15 years through September 2019. However, its annualized return was 45 basis points higher.

The fund beat the Universal Index by 6 basis points annually from its inception in February 2015 through September 2019. And it exhibited slightly lower volatility, likely because it takes considerably less interest-rate risk than the Universal Index. The average duration of its holdings was only 2.5 years at the end of September 2019, while the corresponding figure for the Universal Index was 5.4. This should give the fund an edge in rising rate environments.

Alternatives There aren't any close alternatives. Short-term high-yield ETFs tend to have a less heavy bias toward rate risk than most bond portfolios. Among these, iShares 0-5 Year High Yield Corporate Bond ETF SHYG (0.30% fee), which carries a Morningstar Analyst Rating of Neutral, might be worth considering. However, it probably wouldn't be suitable as a core bond holding.

In contrast, Silver-rated iShares Core Total USD Bond Market ETF IUSB (0.06% fee) is an excellent core bond fund that tracks the Universal Index. This sweeps in both investment-grade and high-yield bonds, giving it a little greater credit risk than the Aggregate Index.

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