STAR Magazine November 2018 | Page 32

STRATEGIC PARTNER CONTENT Rebuild Your Core: Constructing a Bond Portfolio to Prosper in a Changing Environment Chief Investment Officer Sierra Mutual Funds The Bloomberg Barclays U.S. Aggregate Bond Index (The Agg) is often referred to as a “broad exposure to the bond market.” That isn’t true. The reality is the Agg actually represents a narrower slice of the bond market than many investors realize. Its subsets are, and always have been, highly correlated to each other and to U.S. Treasuries, and it excludes important opportunities in fixed income. by Joseph Letts Fixed-income asset classes omitted from the Agg include high-yield corporates, preferred stocks, floating rate loans, emerging markets debt, convertible bonds and more. Intermediate-term bond mutual funds as well as other Agg-centric fixed-income solutions are missing out on opportunities to enhance their risk and returns. Research Analyst Sierra Mutual Funds Agg Problems Today: by Terri Spath, CFA, CFP ® Highest Risk in Three Decades, Limited Bond Market Exposure Historically, the Agg has been associated with a less risky allocation, relative to other asset classes, and has served as a baseline reference for the strength of U.S. bonds. However, the composition of the Agg has changed dramatically over the years, and the net effect is it has become a far riskier yardstick. 31 The STAR | NOVEMBER 2018 The chart spans the past three decades. It illustrates the yield of the Agg, the blue line, declining from roughly six percent in the early 1990s to below 3 percent in recent years. Although the yield of the Agg has risen recently from its lows several years ago, it is still far below its historic levels and has been trending higher since July 2016. What many investors are not familiar with, though, is that the duration of the Agg has reached a 30-year high. On the same chart on the next page, the duration is charted by the gray line. Solution: Rebuild Your Core Interest rates are trending upwards, and at the same time, the Agg is saddled with its highest duration, or interest rate risk, in at least three decades. Simply abandoning bonds or shortening duration are both mistakes. The solution to the problem is to build a bond portfolio that looks like no other by considering high-yield, emerging markets, floating rate, municipals, global and preferred stocks – essentially the other 50 percent of the fixed- income universe excluded in the Agg. The challenge remains when to get in and when to get out? Three steps drive decisions that have historically resulted in better returns with less risk versus the Agg.