Bond ETF Idea: Deconstructing the Agg

Friday, June 8th, 2012

 

by Matt Tucker, iShares

Its building block time again! I recently wrote a post about different ways that ETFs can help investors meet their income objectives. The two options were: 1) “No assembly required,” through a pre-packaged ETF of ETFs such as IYLD (the iShares Morningstar Multi-Asset Income Index Fund), and 2) “DIY,” using individual ETFs as building blocks to construct a customized portfolio. My main point was that a pre-packaged solution can be a great option for investors who don’t have the time, expertise, or inclination to create and continuously manage a portfolio on their own.

For investors who don’t have those challenges, a DIY approach to managing a fixed income portfolio may be the way to go. Each of our fixed income iShares ETFs is essentially its own building block, and they can be combined in a variety of ways to create a wide range of fixed income portfolios.

Why take this approach? For one thing, within the “fixed income” category, there are a variety of sectors that have very different risk and return characteristics. And since fixed income investors can have very distinct goals, meeting portfolio objectives typically requires more than a one-size-fits-all approach. For example, a portfolio that’s designed to generate income should look very different from one that has a goal of delivering alpha.

One strategy we are always talking about with clients is taking a broad benchmark like the Barclays US Aggregate Bond Index (“the Agg”), buying ETFs that represent its various sectors, then tilting exposures based on market factors, sentiment, and/or research calls. It’s kind of like constructing the toy vehicle shown on the building block box, and then giving it your own custom modifications.

The reason investors typically start with the Agg is because it’s generally considered to be a good representation of the broad US fixed income market. It combines six unique fixed income sectors – Treasuries, Agencies, Credit, Mortgage Backed Securities (MBS), Commercial Mortgage Backed Securities (CMBS) and Asset Backed Securities (ABS). As you can see below, each sector has a unique risk and return profile:

Components of the Aggregate – Relationship Between Yield, Duration & Credit Risk

Fixed income ETFs are a great tool for implementing this kind of strategy because, in addition to typically being low cost and tax efficient, there’s such a breadth and depth of products available today. For example, an investor might start with a strategic allocation that mimics the breakdown of the Agg (which is updated on a regular basis here), using ETFs to represent each sector. Then, they can customize based on their specific objectives. If income is the goal, they might lighten up on the lower yielding sectors in order to overweight those that are yielding more. In fact, investors can use our free Fixed Income Portfolio Builder tool (demo here) to explore fixed income portfolios that have the same duration characteristics as the Agg, but with the potential for higher yield. Investors can also make adjustments based on how much credit or duration risk they’re willing to take, or make tactical plays based on the current market environment. The idea is that the fine-tuning is in the investor’s hands.

You have all the blocks, what do you want to build?

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog. You can find more of his posts here.

Source: BlackRock, as of March 2012. Tickers shown in the table are related iShares ETFs that correspond to each index. Indexes used are: iBoxx $ Liquid High Yield Index (HYG), JPMorgan EMBI Global Core Index (EMB), iBoxx $ Liquid Investment Grade Index (LQD), S&P Nat’l AMT-Free Muni Bond Index (MUB), Barclays Capital U.S. Aggregate Bond Index (AGG), Barclays Capital U.S. 1-3 Year Credit Bond Index (CSJ), Barclays Capital U.S. 3-7 Year Treasury Bond Index (IEI), S&P Short Term Nat’l AMT-Free Muni Bond Index (SUB), Barclays Capital U.S. 1-3 Year Treasury Bond Index (SHY), BofA Merrill Lynch 10+ Year US Corporate & Yankees Index (CLY), Barclays Capital Emerging Markets Broad Local Currency Bond Index (LEMB), Barclays Capital U.S. Corporate Aaa – A Capped Index (QLTA). Yield represents the average YTM; Duration represents the effective duration

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

Bonds and bond funds will decrease in value as interest rates rise.
Transactions in shares of the iShares Funds will result in brokerage commissions and will generate tax consequences. iShares Funds are obliged to distribute portfolio gains to shareholders.

 

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Tags: Alpha One, Asset Income, Block Time, Bond Index, Customized Portfolio, Distinct Goals, Diy Approach, ETF, ETFs, Fixed Income Portfolio, Income Category, Income Index, Income Objectives, Index Fund, Market Factors, Matt Tucker, Morningstar, Packaged Solution, Portfolio Objectives, Risk And Return, Time Expertise, Toy Vehicle
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Outlook Remains Positive, Despite Technical Market Factors (Bob Doll)

Tuesday, January 25th, 2011

For the week, the Dow Jones Industrial Average rose 0.72% to 11,872, the S&P 500 Index declined 0.76% to 1,283 and the Nasdaq Composite declined 2.39% to 2,690.  While most other averages declined, this week marked the eighth week of gains by the Dow, which has risen 7% over that span.

A number of technical factors came into play over the past week to interrupt the broader equity rally, although issues related to sovereign debt in Europe account for some fundamental causes as well. In this context, we believe that there are a number of near-term catalysts for potential market correction: strongly bullish sentiment, peripheral country issues in Europe, commodity inflation that could cause further policy tightening in emerging markets, the need to raise the US debt ceiling and bad weather in areas of the United States that could cause a slowdown in the economic recovery. However, looking beyond these technical issues, we believe there is no reason to change our constructive view regarding the recovery and trajectory of the markets.  Growth indicators remain good and are being reinforced by the fourth quarter reporting season, and evidence of flows out of fixed income and into equities should provide a positive supply/demand backdrop.

Last week, initial jobless claims moved lower by 41,000 (based on the revised number) to 404,000 (much better than the expected level of 425,000), undoing most of the prior week’s increase. In addition, December month-over-month home sales rose 13.2%, offering another sign that the economy continues to heal. Fourth-quarter earnings reports continue to beat expectations, though not as much as in previous quarters. The best earnings performances have been in technology and materials, while more mixed reports have come from some of the financial and consumer sectors. The market has rewarded fourth-quarter “earnings beats” in particular when those results are accompanied by top line revenue gains. Companies that have been only cost-cutting have not had their stocks go up. The focus on top line performance is increasingly important, as investors are skeptical of the ability of margins to move higher.

The Federal Reserve released its Summary of Commentary on Current Economic Conditions (known as the “Beige Book”) last week, pointing to continued improvement in overall US economic conditions. Generally better conditions were reported in manufacturing sectors, with strong new orders the main contributor. Another bright spot was the retail sector, which enjoyed a better holiday season in terms of sales than last year. Even auto sales remained upbeat. The labor market appears to be strengthening in most regions, an encouraging sign that payroll figures will start picking up. However, the Beige Book also confirmed that there were few positive signs in the housing area.

A number of factors bear close watching for investors, including the potential for additional Chinese policy tightening, ongoing weakness in the housing market and ongoing European sovereign debt issues. The overall strength of the economy, however, suggests to us that a repeat of the environment of fear that surfaced last year when the Greek sovereign debt problem developed is unlikely. We continue to believe the most important operating assumption for investors is that central bankers and policymakers will do all they can to keep deflation off the table as part of their continued attempts to stimulate the economy. The main goal will be to spur job growth, and there is little worry about the long-term impact of inflation. We believe the strength in profit margins coupled with a less-hostile regulatory posture by Washington, D.C., should spur increased confidence, which should lead to a pickup in employment. With continued progress along this trajectory, we believe we will move into a more virtuous and self-fulfilling economic cycle.

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Sources: BlackRock; Bank Credit Analyst. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 24, 2011, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Tags: Bad Weather, Bob Doll, Bullish Sentiment, Constructive View, Consumer Sectors, Currency, Debt Ceiling, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Earnings Reports, Emerging Markets, Fourth Quarter Earnings, Fundamental Causes, Growth Indicators, Initial Jobless Claims, Market Factors, Nasdaq Composite, Reporting Season, Rose 13, Sovereign Debt, Technical Factors
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