Friday, November 20, 2009

Selecting a Domestic Fixed Income Benchmark

Barclays Aggregate is Yielding Just 3.35%

Last month I detailed that the yield to worst of the Barclays Capital Aggregate Bond Index (i.e. the most popular US dollar fixed income benchmark) was minuscule at just around 3.5%. Well it is now yielding just 3.35% and as a reminder, that is really all you can expect to receive (details here).

As a background, this benchmark is around 40% Government Related bonds, 40% securitized bonds (mainly Agency MBS - i.e. mortgages guaranteed by the government / agencies), and 20% Investment Grade Corporates. With low Treasury yields, rich Agency MBS after $1.25 Trillion in Fed purchases through Q1 '10, and much reduced credit spreads, that 3.35% yield is not necessarily a surprise.

How to Pick up Incremental Yield

There are two main ways for an investor to pick up incremental yield above and beyond that level in this market from their fixed income allocation... move down in quality (i.e. away from Government or Agency MBS to credit) and/or to move out along the yield curve (i.e. the yield curve is STEEP). For this reason, a popular benchmark some investors have moved to is the Long Duration (i.e. out further along the steep yield curve) Government / Credit Index (~50% government related / 50% credit blend).


The Long Government / Credit benchmark has a duration of almost 12 years vs. the Aggregate's ~4 years, thus an investor is not only taking more credit risk (i.e. 50% vs. 20%), but significant duration risk (i.e. exposed to interest rate movements by almost 3x more than the Aggregate index - if interest rates move up 1%, the Aggregate underperforms ~4%, whereas the Long Government / Credit underperforms by ~12% all else equal).

But, How Much Incremental Yield will this Add?

A record amount.

In other words, investors are being compensated 1.8% to take on the incremental credit and duration risk.

Breakdown of Incremental Yield

Below is a quick and dirty breakdown of what makes up that 1.8%. The quick and dirty methodology is as follows; the credit portion [red bars] is taken purely as the spread of the Long Government / Credit Index over the Long Treasury Index (i.e. "risk-free" government bonds), whereas what I label 'Yield Curve Positioning' [blue bars] is everything else being compensated for the move from the Aggregate to the Long Gov't Credit (assume for this Q&D that it is only yield curve positioning).

My Thoughts

In my opinion, duration is relatively attractive on a stand-alone basis, but with the incremental yield that compensates one to take that risk, it becomes very attractive in relative terms. However, that is based on my (non-consensus? see here) view that deflation and another downturn is a higher risk over the next 12 months than the risk of increased rates and/or inflation.

On the other hand I am a bit more cautious with regards to the credit risk associated with the 50% allocation to credit. As a substitute for equities? Definitely. But, I wouldn't be too shocked if spreads widen after the record rally we've seen over the past 7-8 months.

Source: Barclays Capital


  1. Jake,
    We've developed an overlay (AlphaPort) for these benchmarks that I would be happy to show you.
    We added ~200 BPS per annum for a 130/30 overlay and increased sharpe to ~2.5 without adding credit risk.
    Eric Hirschberg

  2. would love to hear how you don't add credit risk if you are adding 100% (130-30) equity beta. are you inferring that equity has no credit risk?

  3. How can you predict anything, when the yield curve is being seriously deformed by the Fed?

  4. it's tough, but unless you want to earn 0% (not necessarily the worst idea) then you have to come up with an approach that utilizes logic and an expectation of things to come

  5. We do take the generalized credit risk of the futures market. But not issue specific credit as all instruments are treasury based.
    100% Equity Beta? you did lose me there. The Overlay +- 30 long short is a treasury based strategy overlayed on the Barclays Intermediate Index

  6. eric-

    now it makes a lot more sense... i thought the 130/30 was an equity overall.

    i'd be happy to take a look at the results if you are willing to share...