In Taoist philosophy, there is an important concept called wu wei, which translates loosely to “doing-by-not-doing.” While Lao Tzu, the 6th century BC author of the Tao Te Ching and founder of Taoism, most assuredly was not writing about fixed income portfolios, the idea of “doing-by-not-doing” aptly applies to what we see happening in passive bond index space today. Many have extolled the virtues of a wu wei approach to investing, and 2016 was a banner year for flows into all sorts of passive strategies through index funds and ETFs. But we think this is no time for wu wei in bonds; in fact, passively getting exposure to the Bloomberg Barclays US Aggregate Bond Index (aka “the Agg”) is downright dangerous today. The Agg --- prevalent in classic “60/40” institutional portfolios and defined contribution target date frameworks --- is aggressively taking on more risk at possibly the worst possible time. (Note: We have also written extensively, more generally, on the problems with indexing a bond portfolio*). There are three main reasons for our concern: the simple math of bond duration; the changing composition of the index; and the very logical financing behavior of corporate borrowers. Bond Math and Duration Without doing a rehash of intricate bond math,
Bond Math and Duration
Without doing a rehash of intricate bond math, duration is an important calculation of bond risk. Though it has many variants, at its root duration measures the sensitivity of a bond’s price to a shift in yields. For example, a bond (or a bond portfolio) with a duration of five years means that for every 1% shift upwards in yields, there is a 5% drop in the price of the bond. Duration is measured in years because it is a function of the timing and magnitude of a bond’s cash flows (coupons and principal repayment): the more distant the cash flows, the higher the sensitivity (i.e., higher risk) to a change in interest rates, all else held equal. The cleanest example of this is the 30-year zero-coupon bond, which pays a single massive cash flow 30 years down the road, and therefore this bond has a duration of exactly 30 years. There are no coupon payments along the way that would dampen its sensitivity to a change in yields. Generally speaking, the smaller the coupon, the higher the duration (and vice versa); the longer the maturity, the higher the duration (and vice versa). That’s just how the math of bond risk works.
Unfortunately for investors in passive bond portfolios or ETFs tied to the Agg, bond math is making this “safer” bond portfolio much riskier than it was even a few years ago. It is now much more sensitive to a possible rise in bond yields (as we saw in November) due simply to a lower “cushion” of coupons. As shown in the chart below, coupons have dropped dramatically since the Financial Crisis of 2008 and the introduction of Quantitative Easing by the Fed. For many years leading up to 2008, the Agg happily paid its investors a healthy coupon of over 5%, but today it is a measly 3%, a number that is among some of the lowest ever recorded. This is problem number one.
Changing Composition of the Agg
Problem number two is that the Agg has dramatically changed its stripes since the Financial Crisis. Eight years ago, the largest bond sector was securitized loans (e.g., ABS, MBS), and most of these types of securities have shorter maturities and duration. Today, longer-dated Treasuries are now the dominant sector of the Agg, while securitized bonds have dropped off significantly. This, again, has shifted both the maturity and duration of the Agg upward.