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A Gold-Rated Bond Fund for Aggregate Bond Market Exposure

While it is conservative relative to peers in the core-plus Morningstar Category, this fund provides great aggregate bond market exposure.

The iShares Core Total US Bond Market ETF IUSB tracks the Bloomberg Barclays U.S. Universal Bond Index, which includes U.S.-dollar-denominated, fixed-rate, taxable bonds across the entire credit spectrum with at least one year until maturity. Charging just 0.06% annually, the fund is among the absolute cheapest in its category.

Morningstar’s new ratings framework, which places more emphasis on fees, has recognized this fund’s low expense ratio as a significant advantage over its peers. As a result of this updated analysis, we have upgraded its Morningstar Analyst Rating to Gold from Silver.

The benchmark index represents a union of the Bloomberg Barclays U.S. Aggregate Bond Index (“the Agg”) with other sectors not represented in the Agg, like high-yield bonds. The additional sectors are small relative to those already contained in the Agg, so there is a large overlap between this fund and the Agg. The inclusion of corporate debt rated below investment-grade enables the fund to generate higher yields and hold on to bonds that are downgraded to junk from investment-grade (“fallen angels”), which may be temporarily undervalued because of concentrated selling pressure from investment-grade managers.

Although this strategy takes more credit risk than the Agg, it takes less credit risk than the Morningstar Core-Plus Bond category average. Bonds rated below investment-grade represented less than 10% of the fund’s assets at the end of November 2019, about half the figure for the category average, while Treasury bonds carried twice the weighting here (35%) as they did in the category average.

While the fund’s lower-than-average credit risk limits its potential return, it should provide better diversification and stronger downside protection. Credit risk is highly correlated to the equity market, so taking less credit risk will yield a portfolio that performs better when economic conditions worsen and credit spreads widen.

Process This broad, market-value-weighted portfolio reflects the composition of the U.S.-dollar-denominated bond market, harnessing the market's collective wisdom. It also mitigates transaction costs by keeping turnover low and tilting toward the largest bond issues, which tend to be the cheapest to trade. The inclusion of both investment-grade and high-yield bonds, which account for a small portion of the portfolio, improves diversification and expected returns, without significantly increasing risk. The strategy earns an Above Average Process Pillar rating.

The fund employs representative sampling to mirror the performance of the Bloomberg Barclays U.S. Universal Bond Index, which includes U.S.-dollar-denominated, fixed-rate, taxable bonds across the entire credit spectrum with at least one year until maturity. Corporate, government, and securitized bonds are eligible for inclusion, but Treasury Inflation-Protected Securities and tax-advantaged municipal bonds are not. Qualifying securities are weighted by market value, which pulls the portfolio toward highly rated Treasuries and agency mortgage-backed securities. The index is rebalanced monthly.

This is a good strategy because it covers most of the U.S. bond market, retaining low credit risk, while boosting expected returns with its modest exposure to high-yield debt.

This portfolio takes less credit risk than most of its peers in the core-plus bond category. AAA rated debt represented 61% of this portfolio at the end of November 2019, 35% of which came from Treasuries. While the strategy’s corporate bond holdings matched the category average in terms of total percentage of assets (both roughly at 33%), the fund held half as much of its assets in below-investment-grade corporate debt (roughly 7%). The fund was also 16 percentage points underweight in securitized debt, relative to the category average.

The fund’s Treasury-heavy tilt will limit its potential to generate return. Treasury bonds are backed by the full faith and credit of the U.S. government and contain virtually zero credit risk as a result. But the fund’s conservative tilt should help it provide better downside protection when credit spreads widen and the economy deteriorates. During these periods, lower-quality bonds tend to underperform. The fund’s performance should also be slightly less correlated to the equity market.

The fund’s interest-rate risk is in line with that of the Agg and the core-plus category average. As of November 2019, its average effective duration was approximately 5.5 years.

Performance The strategy's performance from its inception in June 2014 through November 2019, has been solid, if unspectacular. It beat the core-plus bond category average by 6 basis points annualized. During that time the fund's performance, volatility, and risk-adjusted performance each ranked in the category's middle third.

Credit risk has paid off over the fund’s life. This hurt the fund’s category-relative performance, as the fund takes less credit risk than the category average. However, it made up the difference through its low fee advantage.

The strategy’s conservative tilt should enable it to hold up better when credit spreads widen. While the strategy lagged the category average by nearly 50 basis points during calendar 2016 and 2017, when credit spreads tightened, it outperformed the category average by the same amount during the fourth quarter of 2018, when spreads expanded.

As a result, the fund should hold up during periods of tumult. For instance, it outperformed the category average by 1.55% during the period of June 2015 through February 2016, when credit spreads nearly doubled.

The fund lagged its benchmark by just slightly more than 5 basis points annualized since its inception, nearly matching its net expense ratio.

People BlackRock boasts a large and experienced team reinforced by sector specialists, support teams, and centralized trading desks, mitigating key-person risk and underpinning an Above Average People rating.

James Mauro and Scott Radell have acted as the fund’s lead portfolio managers since its inception in 2014. They lead a broader team of sector specialist portfolio managers who are supported by a handful of analysts, as well as a separate trading team, and an index research team. This specialization improves execution and scalability, allowing BlackRock to deliver high-fidelity index-tracking in a cost-efficient manner. The scope of responsibility is broadest for the senior members of the team, while the analysts are responsible for the day-to-day operations of the strategy like processing creation/redemption baskets.

The managers’ compensation is tied to performance, as measured by the tracking difference between the fund and its benchmark. This aligns their interest with investors’.

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