A recent report from the funds research team at State Street Global Advisors (SSGA), one of the world’s largest asset managers and a leading provider of exchange-traded funds, argues that ETFs linked to traditional broad US bond indices, such as the widely followed Barclays US Aggregate Bond Index, may not be serving the needs of investors as efficiently as they once did.

A reduction in diversity within these indices, coupled with expected changes to the dynamics of the fixed income market when interest rates begin to rise, may result in these funds providing sub-optimal exposure to credit and duration risks. This could have ramifications for investors who use popular ETFs such as the iShares US Aggregate Bond UCITS ETF (SUAG) and the SPDR Barclays US Aggregate Bond UCITS ETF (USAG) as their core bond allocations.

Exposure to traditional broad US bond ETFs may leave investors dissatisfied in a rising rate environment.

Since the inception of the index, the corporate bond market has grown in both absolute and relative size, yet the index has no allocation to this market. Consequently, it now only represents 38% of the total US bond market. The index is also market cap weighted, favouring Treasuries and Mortgage-Backed Securities (MBS), two of the lowest yielding, most duration-sensitive fixed income security types in the US bond market. Lastly, the duration of the index has widened to around 5.6 years, increasing by 1 year since 2009, leaving tracking ETFs more susceptible to upcoming rate rises.

The proposed effects of an interest rate hike

Market participants around the world are keeping a close eye on Federal Reserve announcements, as the expected first change in interest rates since December 2008 will likely have a pronounced effect on markets globally; however, there is disagreement as to the effect on the level and shape of the Treasury yield curve.

The SSGA report predicts a reduced effect at the longer end of the maturity spectrum and a consequential flattening of the yield curve:“We expect the Fed to raise rates at the September policy meeting, followed by another possible hike in December. By 2017, in our view, shorter-term interest rates are likely to be the most directly affected by the Fed’s policy moves. At the longer-duration part of the bond market, however, we think the movement will be much more muted.” The report suggests a zero slope co-efficient for the yield curve within a few years.

Three key factors are highlighted that will keep demand for longer-dated T-Bonds robust in the face of a rising rate environment. Firstly, yields of over 2% on these instruments are relatively attractive compared to an average of 1.4% for other G-10 sovereign bonds with a similar maturity. Secondly, continued geopolitical instability in European nations coupled with more rigid regulatory oversight will necessitate increased demand for safe assets from banks and other financial institutions. Lastly, as the number of retirees expands globally, demand for safe, income-producing assets will increase.

Given the low-yields within these traditional broad-market bond ETFs, as well as a prediction that the longer end of the yield curve may not be as affected as in previous tightening cycles, investors are encouraged to re-think their core ETF strategy.

“The time has come to dismantle the Agg (Barclays Index) and reassemble core fixed income portfolios in a way that is better suited for today’s environment. This involves rearranging the Agg’s components, overweighting some, underweighting others and adding in core-like exposures to certain fixed income asset classes that aren’t currently covered in the index,” the report notes.

While current sector allocations within the iShares US Aggregate Bond UCITS ETF and the SPDR Barclays US Aggregate Bond UCITS ETF favour Treasuries (around 37%) and MBS (around 27%), the report provides a hypothetical alternative: 15% allocations to ETFs tracking intermediate-term US government debt as well as ETFs tracking MBS. The remaining 70% can be allocated roughly equally between ETFs tracking investment-grade floating notes, short-term corporate bonds, intermediate-term corporate bonds, high-yield bonds and senior loans.

The hypothetical portfolio produced several superior metrics when compared to the Barclays US Aggregate Index: a yield-to-worst of 2.6% compared to 1.7%; an option-adjusted duration of 2.8 years compared to 5.6 years; an option-adjusted spread of 178bps compared to 55bps; while only sacrificing a composite credit rating of AA+ to a lower A- which is still firmly within the investment-grade bounds.

ETFs are well placed to provide the building blocks of this new core given their efficiency, low transaction costs and narrower bid-ask spreads compared to bond markets with low liquidity.