Barath Sankaran, CFA, Portfolio Manager, Agency MBS, Mortgage & Structured Finance, and Michael Gladchun, Associate Portfolio Manager, Relative Return at Loomis, Sayles & Company, joined Keith Black, Managing Director of RIA Channel, to discuss the implications of the growing weight on government debt in the Bloomberg US Aggregate Bond Index (“Agg”).
The Agg includes US Treasury and Agency debt as well as corporate bonds. There are a variety of drivers of return to these bonds, as corporate bonds have credit risk, mortgage-backed securities have prepayment and convexity risk, and fixed-amortization Treasury securities have interest rate risk. All of these risks are rolled together into the aggregate index, which serves as a benchmark for the US investment-grade bond universe.
The index’s risk profile of credit risk, convexity risk, and interest rate risk changes over time as different bond sectors vary in their index weights. Over the last 10 to 15 years, the weight on Treasuries in the Agg has doubled from 20% to 40%, while adding mortgage-backed securities makes up over 65% of the index. The larger weight on Treasury securities has made the Agg more sensitive to interest rate risk and less sensitive to credit and convexity risks. The duration risk of the Agg, the sensitivity of index returns to changes in interest rates, has increased by about 50% over that same time period. Even though the spread sectors of corporate and mortgage bonds have declined from 80% to 60% weight, the exposure of the index to credit risk has remained relatively stable. Today, the Agg has about twice the exposure to interest rate risk as it does to credit risk. When credit spreads widen, and investors wish to increase exposure to credit risk, they may wish to consider exposure different than the Agg offers.
Sankaran notes that quantitative easing post-2008 has changed the path of interest rates. Before QE, mortgage duration changes ranged from one to four years, while after QE, the range has expanded to zero to eight years, doubling the sensitivity of mortgages. Interest rate volatility has also doubled since the Great Financial Crisis (GFC). In times of tight credit spreads, investors wishing to outperform the Agg need to sharpen their tool kit, which may require hedging interest rate risk.
Mortgage-backed securities (MBS) exhibit negative convexity, as MBS prices don’t rise substantially as interest rates fall. Borrowers can refinance their mortgage as rates decline and keep their mortgage longer when rates rise. That is, homeowners earn the benefits of declining rates, and MBS investors hold the risk of rising rates.
Investors need to be aware of the changing composition of the Agg, which means that quantitative relationships have been changing over time. Indexed investors are now taking more interest rate exposure than in the past. Gladchun notes that the active strategies managed by Loomis, Sayles & Company are shifting a greater weight into bonds that are not tracked by the aggregate index. Adding non-benchmark securities, such as investment-grade collateralized loan obligations, increases portfolio income. Increased income provides some insulation in a rising rate environment.
Resources:
Institutional Fixed Income Strategies
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This marketing communication is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the speakers only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.
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