Fans of low-cost index investing generally view the growing popularity of passive investments as a good thing. But in today’s environment, investors in ETFs and mutual funds that hew closely to U.S. bond indexes are betting the ranch on Uncle Sam, often without being aware of it.
Since bottoming in 2007 at 19% of core U.S. bonds outstanding, Treasurys have more than doubled to 40% of the universe in 2015. Combined with agency debt, U.S. government bonds now represent about 70% of the Barclays U.S. Aggregate Bond Index, and they hold a prominent position in the scores of mutual funds and ETFs that follow the index’s lead as an anchor for sector allocation.
“The bond portion of a portfolio is supposed to act as a kind of anchor,” says Anne Walsh, co-manager of the Guggenheim Total Return Bond Fund. “But in a rising rate environment, traditional index replicators have low yields in the mid-2% range, so it would take a very small move in interest rates to wipe out returns for the year.”
At a coupon rate of 2.125%, for example, it would take a rate increase of only 28 basis points for 10-year U.S. Treasurys to earn a significantly negative total return over a one-year holding period. Aside from interest rate risk, there is also more credit risk in index-weighted ETFs and mutual funds than meets the eye. “The companies that dominate the index are the largest debtors. And when a sector becomes outsized in an index, it often leads to a correction in the future,” Walsh says.
Instead of keeping a large chunk of its assets in U.S. Treasurys and government agency bonds, the fund has less than 7% of assets in them. Its 5% nod to AAA-rated bonds also falls well short of the 32% allocation the index has to this crowded corner of the investment universe.
In place of those bonds, Walsh and her co-managers turn to securities that have little or no weighting in the index but have much higher yields and lower correlation to more traditional fixed-income securities. “These less-trafficked types of bonds are usually not available to retail investors, except through funds,” she says. “They require more work to evaluate and can be difficult for the average investors to understand. Nonetheless, they produce yields comparable to similarly rated corporate bonds, but with significantly less interest rate risk.” To select the securities, a team of 150 professionals evaluates companies, deal structures and industries. The deep bench comes from Guggenheim Investments, which manages more than $200 billion in fixed income, equity and alternative investments.
The non-traditional bonds that have a presence in the fund include a large swath of commercial asset-backed securities and non-agency residential mortgage-backed securities. While the ABS and MBS market gained notoriety during the financial crisis when the underlying loans unraveled, the group bears little resemblance to the troublemakers of yesteryear. Most of the securities in the fund that fall into these categories carry investment-grade ratings, and their floating rates, currently in the 3% to 5% range, provide both an attractive level of income and a cushion against interest rate shocks. They have also helped the fund produce an attractive 30-day SEC yield of 5.05% for its institutional shares as of July 31.
Asset-backed securities now make up about 30% of the portfolio, whereas they make up less than 1% of the Barclays Aggregate. The ABS subsectors represented in that index, and the ones investors are most familiar with, are traditional securitizations backed by credit card receivables, student loans and auto loans. Despite generally improving credit profiles, these subsectors yield only about 1.5%.
Commercial asset-backed securities, which the fund focuses on, are less well-known but yield at least twice as much. These securities are backed by cash flows from the receivables generated by businesses such as leases on shipping containers, aircraft, vehicles and medical equipment. Collateralized loan obligations, a subset of the ABS universe, are investment vehicles that primarily invest in a diversified pool of bank loans. Most asset-backed securities and CLOs in the Guggenheim portfolio carry investment-grade ratings and maturities in the three-to-seven-year range.
Walsh cites airline asset-backed securities as one type the fund looks for. Because airplanes serve as collateral, investors have an additional layer of security. And even if an airline goes bankrupt, flying operations that generate money to pay debtholders can continue. These characteristics make the securities much more attractive than traditional airline bonds, which are much more susceptible to default. Other areas of the transportation industry, such as trains, are facing severe constrictions on bank lending and are using asset-backed securities as a way to fill the void. Like the airline securities, these are also backed by equipment that serves as collateral.
In addition to their yields, which are comparable with or even higher than those of traditional corporate bonds, both commercial asset-backed securities and CLOs have other attractive features. Many offer significant downside protection during times of economic stress because their asset values exceed debt obligations, because they boast reserve accounts and because they have triggers that cut off cash flows to subordinated tranches. Also, the amortizing structures of many asset-backed securities reduce credit exposure over time, since a portion of the principal gets paid down over the life of the security.
Non-agency residential mortgage-backed securities make up another 21% of the Guggenheim portfolio. These bonds are backed by residential mortgage loans issued by banks that don’t have government backing, including jumbo loans and non-conforming mortgages. After the financial crisis, most of the securities plummeted in value as homeowners defaulted and the bonds were assigned ratings below investment grade. The fund began buying the bonds at a steep discount after the economy and housing market improved and default rates became more predictable.
Today, most of the bonds trade at 60% to 100% of par value, depending on the underlying pool of mortgages. “These are now seasoned bonds,” Walsh says. “We have a good idea of how borrowers will behave and the ongoing probability of foreclosure.” Most of them have floating rates in the 3% to 5% range and have a weighted average life of 2.5 years. One relatively new type of non-agency residential mortgage-backed bond the fund has invested in provides an added layer of protection by combining outstanding issues and repackaging them into new bonds with the remaining better quality underlying mortgages.
Another way of controlling risk in the current environment is a “barbell approach” in which the fund populates one side of the portfolio with floating-rate and short-term securities, and the other with securities that mature in 10 years or more. Bonds with higher credit ratings, such as Treasury and agency securities, dominate the longer side of the portfolio. The fund also has about 5% of assets in long-dated taxable municipal bonds purchased through the Build America Bonds program that began after the financial crisis and ended in 2010.
The two sides of the portfolio combine to produce an effective duration of 4.1 years, versus 5.6 years for the Barclays Aggregate. The positioning reflects the expectation that as the Fed raises rates, yields on short- and intermediate-term securities will go up first and the yield curve will flatten. If prior Fed tightening cycles are any indication, long-term rates could end lower than short-term rates as future growth expectations decline. Although the shift is likely to be gradual, the scenario implies greater volatility at the shorter end of the curve, where the fund is protected by the floating rates on its holdings.
While the Guggenheim Total Return fund has been around less than four years, Guggenheim Investments has managed separate accounts for institutional investors much longer than that. In a recent report on the fund, Morningstar analyst Michael Herbst notes that while a representative account “has hit periodic rough patches in risk-averse markets” over the trailing decade ended May 2015, its annualized gain of 7% outpaced the Barclays U.S. Aggregate Bond Index by 2.4 percentage points.
Fund performance has been highly competitive, although shares have been slightly more volatile than the index. Between the fund’s inception in November 2011 and June 30 of this year, its annualized return was 6.96% for I class shares, while the return was 2.51% for the Barclays Aggregate. The latest fund fact sheet indicates the institutional share class has captured 147% of the index’s upside over the three years ending June 30, but just 36% of its downside.
Walsh emphasizes that while the fund’s managers are preparing for rising rates, its flexible positioning is designed to help it weather a broad spectrum of market behavior. Such flexibility will be critical going forward warned Guggenheim chairman of investments and global CIO Scott Minerd, who manages the fund with Walsh. In an article posted on the firm’s website in July, Minerd noted, “Today looks a lot like 2004 or 2005, when investors were blissfully ignorant of what awaited. It is still early, but I get increasingly concerned the longer I see undisciplined investors clamoring for bonds with suspect creditworthiness at ludicrously low yields. Higher rates, higher prices or both are on the horizon.”
