With Federal Reserve’s campaign of raising interest rates well under way, concerns abound about its implications for the fixed income investments. I’m going to do a series of posts looking at the modern bond market dynamics and their implications for investment portfolios.
First off, let’s explore the composition of the investment-grade bond market in this country. The best-known and widely-benchmarked fixed income index is Bloomberg Barclays US Aggregate Bond Index or The AGG. Originally it was created in 1986 as the Lehman AGG and became Barclays AGG after Lehman Brothers collapse during the financial crisis. Here are the main criteria for inclusion in the index:
- Investment grade securities only (rated BBB- or higher), so it excludes High Yield or Junk bonds
- Taxable securities only (no munis, except taxable Build America Bonds)
- Fixed rate coupon – excludes Floating Rate, inflation-adjusted TIPS, etc.
- Denominated in USD
- Minimum amount outstanding is $250mm for most securities so it focuses on large issuers
- Maturity of at least 1 year.
Side note: Believe it or not, there are a few 100-year bonds in the index (such as those issued by the railroad company Norfolk Southern) and a bunch of 50-year ones!
Now let’s apply the above criteria and see what we get when you invest in one of the AGG-based index funds. Exhibit 1 shows the holdings of iShares Core US Aggregate Bond ETF (AGG) broken down by the issuer type. There are 3 main categories:
- Dominated by the U.S. Treasury securities, arguably the safest assets in the world.
- Agency includes bonds issued by the U.S. agencies such as Federal Housing Administration and Ginnie Mae; Government Sponsored Enterprise (GSEs) such as Fannie Mae and Freddie Mac. It also has more unusual issuers such as KfW – a German government-owned development bank, Japan Bank for International Cooperation and Pemex – a Mexican state-owned petroleum company.
- Supranational category includes European Investment Bank (EIB) and International Bank for Reconstruction and Development.
- Sovereign holds USD-denomicated bonds issued by countries such as Philippines, Mexico & Poland
- Local Authority are taxable bonds in the U.S. municipalities as well as Canadian provinces
Securitized (don’t feel bad if your eyes glaze over here)
- MBS Pass-Through are pools of mortgages created from individual loans and then guaranteed by either Government Agencies (Ginnie Mae) or Government-Sponsored Enterprise aka GSE (Fannie Mae and Freddie Mac). Ginnie Maes are guaranteed by the full faith and credit of the U.S. Government, while the status of GSEs is… complicated. They are both under a federal government conservatorship which started after they $200 billion bailout during the financial crisis. But… their bonds are technicially not guaranteed by the U.S. government, only the GSEs themselves. Good luck figuring that one out. The 28% of the AGG in these securities is split roughly 27% in Ginnie Mae, 27% in Freddie Mac and 41% in Fannie Mae.
- Commercial mortgage-backed securities (CMBS) are backed by commercial mortgages rather than residential real estate. It’s a relatively small piece of the bond pie.
- Asset-Backed (ABS) is a tiny portion of the market and doesn’t even show up in Exhibit 1. It includes borrowing for credit cards, auto loans and home equity loans. There is plenty of such debt out there but much of it is subprime and wouldn’t be included in the investment grade index. Also a lot of it is not securitized but held on the banks’ balance sheets.
Corporate – this is debt issued by businesses. Industrial category is sort of catch all, but I plan to dig into it in another post to see what type of companies have the most debt.
Exhibit 1 – AGG Holdings by Issues Type
Before I let you go, I also wanted to address one of the biggest knocks against indexing bonds – too much exposure to Uncle Sam. It is true that roughly 70% of the AGG is some sort of government-related debt, be it Tresuaries, Agencies or mortgage bonds guaranteed by GSE. Only about 30% is backed by corporate issuers (i.e. the real economy). However, this has been the case for much of the past 40 years as shown in Exhibit 2 (or 5 using this borrowed chart). The index started out in late 70’s split roughly 50/50 between government and corporates but quickly evolved closer to the current composition. In fact, corporate exposure has been growing since the financial crisis as companies took advantage of the low interest rates to finance mergers and stock buybacks.
Exhibit 2 – Historical AGG Weights by Issuer Type