Bond indexes bend under weight of treasury debt
U.S. government is borrowing $129B of notes this week, up 28% from a year ago
The surge in U.S. government borrowing is beginning to warp bond indexes, posing a challenge for investors looking for the best returns when interest rates are rising.
The problem: Treasurys tend to offer investors lower yields and produce weaker returns than other kinds of bonds, such as high-quality company debt or securities backed by mortgage payments. Yet as the government steps up borrowing to fund last year’s tax cuts, index funds end up holding more Treasurys, squeezing out the securities that pay higher rates of interest.
The U.S. government is borrowing $129 billion (U.S.) this week, up 28% from the same series of note auctions a year ago. The increased borrowing means Treasurys now amount to almost 40% of the value in the leading bond market investment benchmark—the Bloomberg Barclays U.S. aggregate index—which fund managers use to gauge their success. That is up from around 20% in 2006, before the start of the financial crisis.
Some analysts said investors should consider the growing weight of Treasurys in indexes before purchasing mutual funds. Actively managed bond funds have performed better than their
index-tracking peers recently, a trend some analysts credit to their efforts to pare back Treasury holdings. Rising rates erode the value of outstanding bonds, because newly issued debt offers higher payouts. And Federal Reserve officials have penciled in additional increases into 2020.
“The value from active management is going to be more important,” said Kathleen Gaffney, director of diversified fixed income at Eaton Vance, who bought dollar-denominated corporate bonds in emerging markets because U.S. corporate yields remain low by historic measures. “You’re not going to want market risk.”
Through the first six months of this year, active managers
topped indexes in five of 14 categories including municipal bonds and short- and intermediate taxable bonds, according to data from S&P Dow Jones Indices. That is coming off a 2017 in which actively managed funds had their best year since 2012, when active managers beat passive funds in nine of 13 categories the firm then measured.
Pacific Investment Management Co.’s Total Return exchange-traded fund—a smaller, more liquid version of one of the largest actively managed bond mutual funds in the world—has posted a negative return of roughly 1.7% this year, counting price changes and interest payments.
The Bloomberg Barclays aggregate index of U.S. bonds has returned minus 2%.
Should yields continue to rise, advocates of active portfolio management say investors would be better served by a human being shielding them from the parts of the bond market most likely to suffer losses versus an index which includes all bonds, without regard to their potential risks.
“This is going to be a test for active managers at how skillful they are at positioning for a higher interest-rate environment,” said Aye Soe, managing director of global research and design at S&P Dow Jones Indices.
It is a situation many expect to persist, with the Treasury Department expected to run trillion-dollar deficits for the foreseeable future. As issuance increases, funds that use the Bloomberg Barclays aggregate index as a guidepost for portfolio composition will wind up owning increasingly large amounts of Treasury debt. Independent bond analyst David Ader predicts Treasurys will make up half of the U.S. bond market and the indexes that track it by 2028.
Still, because many individuals invest in bond funds to protect against losses in their stock portfolios, there are advantages to indexes that reflect the constituency of bond market borrowers instead of optimizing returns, said Josh Barrickman, who manages Vanguard Group’s bond index fund. While corporate bonds, for example, offer higher yields than Treasurys, U.S. government debt tends to post high returns during periods when investors shun risk, he said.
The changing composition of bond market indexes can exert a powerful force over what resides within their bond mutual funds without their becoming aware of it, according to fund managers and analysts. Treasury Department data shows that the category of investors that represents mutual funds bought about one half of the $2 trillion of U.S. government notes and bonds sold at auction last year. That is up from about one-fifth of the $2.2 trillion sold in 2010.
Should slowing growth lead business conditions to worsen, corporations have the option of borrowing less. Not so the U.S. government.
Because legally mandated spending on unemployment insurance and other safety net programs tends to rise when growth slows, wider budget deficits and more Treasury debt could ensue.
That means many bond investors could face conditions where there is no alternative to holding a rising share of government debt.