Fixed income: straying from the herd
The Bloomberg Barclays US Aggregate Bond Index (Agg) is the most popular benchmark for the investment-grade, US taxable bond market. Trillions of dollars are invested in passive bond strategies that track the index, and countless more assets are parked in quasi-active funds that loosely shadow the Agg.
Sometimes there are reasons to follow the herd—but not always. We feel that there’s an argument to be made for taking an active approach with your core fixed income portfolio—one that deviates from this benchmark in a meaningful way.
Consider the makeup of the Agg, which includes Treasuries, government-related securities, corporate bonds, Agency Mortgage Backed Securities (MBS), Asset Backed Securities (ABS) and Commercial Mortgage Backed Securities (CMBS). For purposes of this argument, we focus in on MBS, which made up more than 27% of the Agg by weight, as of May 2021. That’s a significant bet on an asset class that we view as inferior for many fixed income investors.
It’s important to understand that one of the key risks of investing in MBS is prepayment risk. MBS investments tend to work best in periods of low rate volatility. When interest rates increase the prepayment of the home mortgages underlying Agency MBS are prepaid at a slower rate. Thus, the duration—a measure of interest rate sensitivity—increases. In industry parlance, these bonds “extend.”
The opposite happens when interest rates fall—prepayments accelerate and principal is returned at a faster speed since homeowners have an incentive to refinance. The bonds are then paid off and investors may not get to benefit from the price appreciation they expected. This behavior is inherent to how MBS operate and makes it harder to manage duration of a broader portfolio. It’s one reason why we prefer to strategically underweight MBS in our core fixed income strategies.
There’s another important dynamic to consider regarding the nature of some MBS buyers and how it might skew valuations and the supply and demand dynamics. For example, banks may use MBS to meet some of their capital requirements and ratios so that they pass periodic stress tests, while index funds (including those that track the Agg) are forced buyers by mandate. And let’s not forget the biggest buyer of them all. The Fed is currently buying an estimated $40 billion of MBS every month. What happens with MBS when the Fed inevitably pivots again? It gets tricky.
So, why would anyone purchase MBS? Investors typically are compensated for their prepayment risk through a higher yield on MBS when compared to similar duration Treasury securities. On the surface that makes sense—more risk nets more yield. However, we think a focus on credit (i.e. corporate bonds) is a better and more repeatable way to earn a yield advantage over Treasury securities, especially in the current environment.
Rather than rolling with a large allocation of MBS, which can be sensitive to changes in interest rates and prepayment assumptions, we favor an approach to fixed income portfolio construction using careful credit selection. Taking on credit risk—which can be managed via detailed fundamental analysis—may be preferable than taking on interest rate risk and the oft-shifting changing duration associated with MBS. In lieu of the typical MBS allocation, we prefer Treasury securities and Agency CMBS, which can take on that role of limiting portfolio credit risk, similar to MBS, but importantly they provide a more definitive duration profile due to stronger call protection.
Thus, differentiating from the benchmark and strategically underweighting MBS—certainly less than the 27% currently in the Agg—allows us to manage duration relative to a benchmark within an acceptable range. Importantly, it provides more flexibility to not respond immediately to volatility-driven duration changes in the benchmark. This is one reason we stray from the herd and advocate an active approach to fixed income.