Wednesday, March 4, 2020

The hidden fixed income benchmark risk - Is this what you want? Is this what you expect?

Grab a tiger by the tail. You have to hang on and cannot let go. This is the same as investing in the Bloomberg Barclays AGG index. One of the more important practical risk issues in fixed income concerns the changing composition of the benchmark index. See "THE PASSIVE AGGRESSIVE AGG, REVISITED Passive investing in bonds today turns prudence on its head" by Peter Chiappinelli. The AGG index has gotten significantly risker, but the problem is that it serves as the key benchmark for many investors. 

If you de-risk from the established benchmark, you will underperform in a declining rate environment. If you hold benchmark positions, you are taking on greater risk than previously held when the index had less risky attributes. Of course, no one is complaining given this duration increase is coming when rates are declining and credit spreads have been improving. Given the nice negative correlation with equities, this increase in risk has provided both diversification and safety. 

While there is a positive convexity component from longer duration when rates fall and potentially shorter duration if rates rise, there are issues with the AGG index composition. Mortgage exposure which has shorter duration and negative convexity has declined and credit risk has increased. The composition of the credit risk has moved to lower quality with BBB-rated debt. Treasury risk has also increased.

In ten years, the duration of the index has increased by over 50%.

Surprisingly, unlike their equity brothers, managers have been able to outperform the Bloomberg Barclay AGG index, but this has often been through holding even more credit and duration risk.

The reach for yield has been achieved through higher risk from just following the index. In the last week, the long duration has been a benefit, but the credit exposure has been a total return drag. The question for investor is, nevertheless, complex. Is this what you expect, and is this what you want? 

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