Due to their weighting methodology, aggregate bond exchange traded funds have increasingly accumulated a larger tilt toward U.S. Treasuries. As rates begin to rise, ETFs with heavier positions in higher duration Treasury bonds could begin to lag other fund strategies.
Aggregate bond ETFs, or funds with broad bond exposure, are weighted by market capitalization, so issuers with the largest amount of cumulative debt outstanding have a larger weight in the index.
Ever since the turn of the millennium, the U.S. government has issued more debt at a faster pace than corporations in order to pay for the expanding federal deficit, writes Morningstar analyst Thomas Boccellari. Consequently, the percentage of U.S. Treasuries in the Aggregate Bond Index has jumped to 40% from 16%.
For instance, the Vanguard Total Bond Market ETF (NYSEArca: BND) has a 42% weight in Treasury/Agency bonds and iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG) includes 36.7% in Treasuries. AGG tracks the Barclays Aggregate Bond Index, and BND follows the Barclays U.S. Aggregate Float Adjusted Index, which excludes mortgage-backed bonds held on the government’s balance sheet.
The heavier position to Treasuries has helped funds like BND and AGG to outperform during periods of duress due to their large exposure to safe-haven Treasuries.
“The index’s lower risk profile could help when investors need it the most,” Boccellari said.
However, the analyst argues that funds with a lower duration and a greater exposure to corporate bonds would outperform the Aggregate Index in a rising interest rate environment when the economy is expanding.
“Treasuries and government-backed bonds have historically provided poorer risk-adjusted returns (as measured by the Sharpe ratio) than investment-grade corporate bonds of similar duration,” Boccellari added, pointing to the better returns of corporate investment-grade bonds over the trailing one-, three-, five-, 10- and 15-year periods. [Bond ETFs Still Provide Suitable Risk-Adjusted Returns]
Fixed-income investors can also manually adjust their bond exposure through ETFs. For instance, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD) provides exposure to investment-grade quality corporate debt, and the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) both track high-yield corporate debt that offer better yield compensation for their interest-rate risk, compared to benchmark Treasuries. LQD has a 3.04% 30-day SEC yield, HYG has a 4.82% 30-day SEC yield and JNK has a 5.25% 30-day SEC yield. [Institutional Investors Jump On Cheaper Junk Bonds, ETFs]
However, those who are more concerned about the affect rising rates can have on fixed-income assets can also go down the corporate yield curve with short-duration ETFs. For instance, the Vanguard Short-Term Corporate Bond Index (NYSEArca: VCSH) has a 2.9 year average duration, SPDR Barclays Short Term High Yield Bond ETF (NYSEArca: SJNK) has a 2.24 year duration and iShares 0-5 Year High Yield Corporate Bond ETF (NYSEArca: SHYG) has a 2.25 year duration.
For more information on fixed-income funds, visit our bond ETFs category.
Max Chen contributed to this article.