Ultra-low interest rates and a flood of debt issuance by US companies have led to a silent accumulation of risks in some of the world’s largest bond funds.
Exchange traded funds managed by BlackRock, Vanguard, Charles Schwab and State Street control assets of about $140bn that follow the Bloomberg Barclays US Aggregate bond index, the most important benchmark in fixed income markets globally.
Additional trillions of dollars reside in mutual fund trackers and institutional mandates based on this index, known as the “Agg”, which plays a similar role for bond investors as the S&P 500 in the US equity market. Retail investors account for $1.7tn, up more than 180 per cent over the past decade.
But soaring US bond prices and record low yields have increased the risk of losses for investors in Agg tracking funds, according to GMO, the Boston-based fund manager.
The US 10-year Treasury bond yield dropped to an all-time low at 1.47 per cent in September while the average yield across US investment grade bonds is currently hovering at a record low of 2.57 per cent.
As a result, the yield on the Agg has fallen to 2.6 per cent, which has led to a significant increase in its duration — the risk of losses if interest rates rise.
“The Agg is a portfolio that has turned prudence on its head,” said Peter Chiappinelli, a member of GMO’s asset allocation team.
Ultra-low interest rates have led to a massive increase in debt issuance by US companies, which has surpassed $13.6tn over the past decade, according to the Securities Industry and Financial Markets Association, a trade body.
This has been accompanied by a deterioration in the quality of the corporate bonds held by the Agg, with more than half rated as BBB at a time when US companies’ capacity to service their debt from earnings has weakened.
The real yield (after inflation) of the Agg is also close to zero and future returns are predicted to be lower than those achieved historically.
“The Agg offers some of the lowest expected returns in its history,” said Mr Chiappinelli.
BlackRock expects the Agg to deliver annualised returns of 1.8 per cent over the next decade.
BlackRock’s $74.3bn iShares US aggregate bond ETF, the largest exchange traded fund, which tracks the Agg index, attracted net inflows of $8.8bn last year. It returned 8.68 per cent in 2019 and has delivered annualised returns of 4.05 per cent since inception in September 2003.
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Vanguard’s $259bn Total Bond Market Index fund tracks a modified version of the Agg index. This fund returned 8.82 per cent last year and has delivered annualised returns of 5.88 per cent since inception in November 1986.
Although Vanguard does not expect any material increase in returns from fixed income over the foreseeable future, it views US bonds as fairly valued because of loose monetary policy as well as the subdued outlook for economic growth and inflation.
“Expected returns for fixed income are modest, but this makes it all the more important to remember why you hold bonds in a portfolio in the first place – as ballast for portfolio’s equity risk. This hasn’t changed,” said Josh Barrickman, Americas head of fixed income indexing at Vanguard.
