Most Popular ArticlesFixed Income Investment: What's the Index Doing for You?
Thornburg Investment Management
Jason Brady
February 23, 2010
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Money flows into the fixed income asset class over the course of the past 12 months have been substantial, to say the least. After a decade of negative returns in stocks, investors are facing a greater income need from their portfolios. In addition, the safety and security of “bonds” are beginning to look good both on an absolute basis and as a larger part of any portfolio. Not surprisingly, a large number of investors are pursuing their fixed income investments via index funds or funds that closely match a fixed income index. But these same investors may not have a good idea of what the “index” is. Unlike the S&P 500 Index, the most common fixed income index, the Barclays Capital Aggregate Bond Index, is comprised of thousands of securities picked not due to their size or relevance, but merely their presence in the market. As a result, the index constituents and characteristics can change rather dramatically over the course of a reasonable investment time horizon of, say, two or three years. In addition, the index itself may not match an investor’s needs for either lower volatility or income. So let’s take a look at what the Barclays Capital Aggregate Bond Index (bcai) actually is. Formerly known as the Lehman Aggregate, the bcai is reconstituted monthly and consists of reasonably large (e.g. $250 million issue size for corporate bonds) investment-grade bond issues denominated in U.S. dollars. Simple enough, but because that is the extent of the filter, the composition of the index can, and has, changed fairly significantly with changing issuance patterns over the years. Government Backed Debt in the Barclays Capital Aggregate Bond Index
Source: Barclays Capital, as of 12/31/2009
As of December 31, 2009, the bcai was 75% government backed. U.S. Treasuries made up 28% of the index, Government Sponsored Entity (gse) Debt (Agency Debt) made up 10%, and gse-backed mortgage securities represented 37%. This high preponderance of U.S. government debt makes the changes in U.S. policy very significant for the performance of the index as a whole, as well as for funds that closely follow that index. With the very high quality of the index and relatively low income, changes in the price of money for the U.S. government are reflected in the changes in price for the debt closely tied to it. In addition, the United States is planning on more debt issuance going forward, with the Congressional Budget Office predicting deficits to stay at very high levels of gdp. This will mean that the U.S. Treasury portion of the bcai is likely to continue to increase. Barclays Capital Aggregate Bond Index Composition
Source: Barclays Capital. 2010 data is projected.
GSE mortgages, at 37% of the index, provide a different source of volatility. While the yields on these instruments are higher than U.S. Treasuries, the prepayment structure of many of these bonds means that the duration, or interest rate sensitivity, of this portion of the index can change from month to month. Consider a typical home mortgage. When rates move lower, the home-owner is likely to refinance at a lower rate, presenting the bondholder with principal payments exactly when she does not want them. However, when rates move higher, the homeowner is likely to pay down principal less quickly, meaning the bondholder receives less principal exactly when she wants to reinvest more. This is called by the fancy term “negative convexity,” but basically means that mortgages pay you back when you least want those payments. In return, the investor receives more yield. Consider the current situation, where housing prices are depressed, interest rates are very low, and the Federal Reserve is actively trying to keep mortgage rates low. It seems to me that the likelihood is high that prepayments will slow down or remain slow; mortgage rates are unlikely to go significantly lower. If they move higher, then bondholders will have bonds that looked like two- or three-year bonds when prepayments were faster and now suddenly look like seven- or eight-year bonds. In other words, investors will be locked into lower-rate securities for longer when rates move up. Prices will move down more than those bondholders may currently expect, because when rates move higher, bond prices move lower and longer-duration bonds move more in price. Below is a graph of the duration (or interest rate sensitivity) of the gse mortgage portion of the index along with that of the index itself. As you can see, it has moved significantly higher over the course of the last several months, making investors more exposed to interest rate moves, just as interest rates have moved higher, making bond prices lower. In fact, the portion of the bcai that is longer than 10 years has moved from 11.5% to 14.5% in the course of the last two months, merely because several large mortgage issues have extended their duration. Duration: Barclays Capital Aggregate Bond Index vs. MBS and Corporate Bonds
Source: Barclays Capital
As to income, currently the composition of the bcai is 78% aaa, with an average credit quality of aa. While that sounds good for those seeking safety, it is less appropriate for those looking for yield. Though the aa average credit quality and high percentage of government bonds means that there is much less credit risk in the index, it also discards the possibility of earning additional returns from more credit exposure. To be sure, 2008 showed the danger of investing in low-quality bonds and investors are right to be careful about credit risk. However, with a holding period of two years, high-grade credit investors have been rewarded with considerable returns in 2009, making up for much of the 2008 disaster. From an income perspective, the yield on the bcai as a whole is 3.68%, while the yield on the 19% of the index that is investment-grade corporate bonds (average rating of a) is 4.73%. In addition, corporate bonds are largely bullets, meaning that prepayment risk is not present. Thornburg Investment Management runs two taxable bond funds that strive to be core funds for investors seeking lower volatility, low-to-negative correlation with equities, and a reasonable income/risk tradeoff. The Thornburg Limited Term Income Fund (A Shares: thifx) has many of the same constituent parts as the bcai, but with higher yield, lower duration, and only slightly lower credit quality. The Thornburg Limited Term U.S. Government Fund (A Shares: ltusx) actually has a fairly similar composition to the bcai from an asset class standpoint. However, the gse mortgage securities within the fund are largely structured to mitigate the possible “extension” or adverse prepayment risk at the cost of a slightly lower yield. In both cases, though the Thornburg funds are “Limited Term” and have a lower duration than the index, these funds invest in bonds with maturities or average lives of between 0 and 10 years. Because so few bonds are issued beyond 10 years (only 14.5% of the bonds in the bcai are longer than 10 years), the investment universe is fairly similar. Thornburg Funds vs. Yield Duration Avg Credit Quality THIFX 4.18% 3.61 yrs AA LTUSX 4.28% 2.81 yrs AAA BCAI 3.68% 4.57 yrs AA1/AA2 Source: Barclays Capital, as of 12/31/2009. Fund yields are class A share 30-day distribution yields. Index yield is yield to worst. A combination of high negative convexity, low yield, and longer duration makes the Barclays Capital Aggregate Bond Index an imperfect model for many investors seeking fixed income exposure. At Thornburg Investment Management, our core funds look different from the index because we believe that our mandate of lower volatility, low-to-negative correlation with equities, and a reasonable risk/reward tradeoff combined with consistent income is better served by focusing our holdings in different ways. We believe that this approach will continue to be successful in navigating the difficult waters of the current markets, just as it has for the past 25 years. Performance as of 12/31/09
30-Day SEC Yield: 3.10%
30-Day SEC Yield: 2.73% Barclays Capital Aggregate Bond Index
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, visit thornburg.com. Class A shares have a maximum sales charge of 1.50%.
The views expressed by Mr. Brady reflect his professional opinion and should not be considered buy or sell recommendations. These views are subject to change. There is no guarantee the funds will meet their investment objectives. Not FDIC Insured • May Lose Value • No Bank Guarantee Before investing, carefully consider each Fund’s investment goals, risks, charges, and expenses. For a prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read it carefully before investing. Thornburg Funds are distributed by Thornburg Securities Corporation.® • 2300 North Ridgetop Road • Santa Fe, NM 87506 • 877.215.1330 • thornburg.com
(c) Thornburg Investment Management
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