Rethinking AGG: One Stop Fixed Income Exposure?

by on July 26, 2010 | ETFs Mentioned:

The tremendous surge in ETF assets in recent years has been attributable not to equity funds, but rather to products offering exposure to other asset classes. The number of exchange-traded commodity products has surged, enabling investors to establish exposure to everything from copper to sugar through the exchange-traded structure. Another big growth area has focused around fixed income funds, as investors have become more comfortable with the idea of accessing bonds through ETFs.

The last year has seen a tremendous amount of innovation in the fixed income ETF space. iShares debuted a line of “target end date” municipal bond ETFs, and Claymore has pioneered a similar concept in the corporate bond space. While these more granular products have gained some traction, the most popular bond ETFs are broad-based funds that offer exposure to various types of securities through a single ticker. The largest ETF in the Total Bond Market ETFdb Category is the iShares Barclays Aggregate Bond Fund (AGG); this $11 billion fund tracks the Barclays Capital U.S. Aggregate Bond Index, a benchmark designed to measure the performance of the U.S. investment grade bond market. The index underlying AGG has more than 8,000 individual holdings, making it one of the broadest benchmarks measuring the fixed income asset class.

Many investors view AGG as a “one stop shop” for fixed income exposure, utilizing the fund as the sole component of the fixed income portion of their portfolio. For those investors, it might be time to take a closer look at AGG, and perhaps consider reconstructing the fixed income portion of a portfolio [also see AGG vs. BND: What's The Difference?].

Shift To Treasuries

Over the last two years, the U.S. government has implemented aggressive stimulus plans designed to spur spending and lift the economy out of a recession. Most investors are well aware of the impact such borrowing has on the country’s budget and the ability to expand government spending. But few have considered the impact these programs have had on fixed income benchmarks. As the government’s outstanding debt balance has grown, so too has the portion of “aggregate” bond indexes allocated to Treasuries. Currently, more than 30% of AGG’s assets are in Treasuries, with another 40% or so in securities issued by FNMA, FHLMC, GNMA, or other U.S. agencies [see breakdown of AGG holdings]. With each round of new Treasuries auctions, AGG begins to more closely resemble some of the funds that make up the Government Bonds ETFdb Category.

This phenomenon highlights one of the issues that has made some investors uncomfortable with the thought of achieving fixed income exposure through ETFs in the first place. Many of the indexes underlying popular bond ETF products weren’t designed to be investable assets, but rather hypothetical measures of the performance of a broad market. This is clearly the case with the Barclays Capital Aggregate Bond Index; many of the underlying securities are less than liquid, and assembling a portfolio with 8,000-plus securities is impractical.

On top of that, the allocation of aggregate bond indexes is subject to change based on broad, macroeconomic developments; a significant increase in government debt has been reflected in the makeup of funds like AGG, which now have big allocations to government bonds.

This shift has come primarily at the expense of investment grade corporate bonds; only about 20% of AGG’s assets are allocated this corner of the fixed income market that many investors have embraced as a means of achieving attractive current returns in a low-yield environment. Given its low expense ratio and impressive depth of holdings, AGG is still a fine core holding for the fixed income asset class (as is Vanguard’s BND). But for investors looking to establish more well-rounded bond exposure (and increase yields), we highlight some options that could serve as effective complements to Total Bond Market ETFs:

  • iShares iBoxx $ Investment Grade Corporate Bond Index Fund (LQD): This ETF offers exposure to investment grade corporate bonds by seeking to replicate the performance of the iBoxx $ Liquid Investment Grade Index. In total, LQD has more than 400 holdings, and allocates only about 10% of total assets to its top ten holdings. The vast majority of the underlying holdings have a coupon of 5% or more, making LQD an interesting option for those looking to boost yields without taking on excessive risk [view all ETFs in the Corporate Bonds ETFdb Category].
  • SPDR Barclays Capital High Yield Bond ETF (JNK): This fund focuses on a corner of the bond market that isn’t covered at all by AGG: junk bonds. These securities tend to have higher risk of default, but offer more attractive yields than investment grade securities; most of the underlying holdings pay dividends of 8% or more [see complete breakdown of JNK's holdings].
  • S&P National Municipal Bond Fund (MUB): This ETF offers exposure to municipal bonds, another corner of the fixed income market that isn’t covered by most total bond market funds. Because the coupon payments are often exempt from income taxes, muni bonds can be very attractive to investors in high tax brackets.

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Disclosure: No positions at time of writing.