In 2018, the Bloomberg Barclays Aggregate Bond Index (BBAB) eked out a whopping 0.01% return and thus preserved a rather remarkable streak of only having one negative year since 1999. What’s new in the evolving construct of the BBAB index, and do you know the risks that are creeping into the bond markets?
First, lets test your knowledge of the Bloomberg Barclays Aggregate Bond Index (BBAB).
Once you’ve answered all three questions, scroll down to to see the answers. No peeking!
1. What do you think the change in duration of the BBAB has been over the last decade?
- The duration of the BBAB does not change
- The duration of the BBAB has decreased in recent years as interest rates have decreased
- The duration increases automatically when the index is rebalanced
- The duration increases based on when the FED increases short-term rates
- None of the above
2. Which of the following types of bonds are NOT included in the Bloomberg Barclays Aggregate Bond Index?
- High Yield (junk) bonds
- Municipal bonds
- Treasury Inflation Protected Bonds (TIPS)
- Most commercial mortgage bonds
- All of the above
3. How is the index constructed?
- Market capitalization like the S&P 500
- Bloomberg-Barclay’s discretion
- The amount of debt issued and outstanding
- U.S. Government guidelines
- The quality of the debt (high to low ratings)
Question 1: What do you think the change in duration of the BBAB has been over the last decade?
Answer: E – none of these.
Let’s begin by discussing duration risk. As a reminder, duration risk is the measurement of price sensitivity of a bond due to a change in interest rates over its time to maturity. The BBAB has seen its duration rise from a low of 3.71 years in December 2008 to 5.87 years as of the beginning of February 2019. This seemingly innocent two-year extension in duration is actually a 58% increase. This means that if bond yields rise 1%, the new, longer duration will cause additional losses of roughly 2% to investors. This is not insignificant, especially if the trend continues.
Types of Bonds
Question 2: Which of the following types of bonds are NOT included in the Bloomberg Barclays Aggregate Bond Index?
Answer: E – All of the above!
Did you guess correctly? A notable amount of today’s domestic bond market is not included in the “Aggregate” index and we need to ensure that we all know what is included in and excluded from the benchmark.
In addition to the many types of bonds excluded from the index, the BBAB still does not offer much diversification. About two-thirds of the index is in two types of bonds: U.S. treasuries and mortgage-backed securities (just like the current FED’s balance sheet). These two have an ~82% correlation, which means that they will act similarly when interest rates move. If you add in U.S. corporate bonds, 91% of the index is covered in only three asset classes. How much diversification can the remaining 9% provide?
Question 3: How is the index constructed?
Answer: C – The amount of debt issued and outstanding
The BBAB is constructed by including more bonds of those entities with the highest amount of debt. As the U.S. Government’s debt increases, due to the sheer scale of the bonds issued to cover this debt, it simply means more and more of the index will become U.S. Treasuries over time. Treasuries aside, more debt outstanding does not speak to the quality of the debt or the ability to repay the debt, it simply means there is more of these issues included in the index. Would you buy a stock because they have the most shares outstanding? The construct of the index makes one pause.
Check back next Tuesday, 3/5/19 for Part 2 of this piece on bonds!