Main Thesis

The purpose of this article is to evaluate the iShares Core U.S. Aggregate Bond ETF (AGG) as an investment option. As my readers know, I have been advocating buying positions that hedge against equity risk for the past few months. In the short run, this trade has worked, with equities seeing a pullback off their highs. Looking ahead, I am maintaining this outlook, but feel it is necessary to manage expectations for fixed-income investors now. With interest rates having move markedly lower, the yields offered by popular funds like AGG are quite low. Further, the effective duration of many bond funds has been creeping higher, as bond issuers are locking in low rates for longer time periods. This raises the duration, or interest rate, risk for new positions. While AGG has a negative correlation to equities and will, therefore, come in handy if stocks do decline more, the upside potential seems fairly limited in my view.

Background

First, a little about AGG. It is an ETF with a primary objective “to track the investment results of an index composed of the total U.S. investment-grade bond market.” Currently, the fund trades at $118.30/share and pays monthly distributions, with yield of 2.32%. I reviewed AGG back in early June and felt the environment would continue to favor fixed-income. Looking back, equities performed better than I anticipated, but AGG has delivered a positive return:

Source: Seeking Alpha

As we approach the final months of the year, I continue to believe equities will face a rocky road. Thus, I am adding most of my new cash to fixed-income positions. However, many corners of fixed income, including aggregate funds like AGG, also appear expensive given their inherent risks. Therefore, while I see merit to owning AGG, I feel it is prudent to manage expectations on what the rest of 2020 will bring. I see a best-case scenario of low single-digit returns going forward and, therefore, believe a neutral rating is warranted.

The Merits To Owning AGG Are Still Valid

As my title alluded, I am getting a bit more cautious on AGG. However, I am similarly worried about the state of the equity market, so it is fair to say that finding the right place to put new cash is a challenge for me at the moment. With that in mind, I want to touch on a reason why investors would still want to consider AGG, even if they believe upside is limited. Simply, the fund continues to offer a reasonable way to hedge exposure to the equity market. While the correlation with equities rose for bonds as a whole during Q2, a negative correlation still existed for aggregate bond funds. While this correlation remains elevated, on a historical level, the hedge is still apparent with the correlation sitting near -0.2, as shown below:

Source: Pionline

It should be clear that funds like AGG still offer investors a way to protect against downside risk in equities. Further, the graph also shows that corporate bonds have seen their correlation with equities rise dramatically in 2020. Therefore, for investors who want to use bonds as a hedge, moving into aggregate funds, which own multiple different sectors, may make more sense than buying corporate bonds in isolation.

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Of course, investors will want to consider their own outlook for equities before buying AGG. Given that the fund is back near pre-crisis levels, it is safe to assume further upside is limited and will depend on forthcoming volatility in the equity market. Fortunately (or unfortunately depending on your perspective), the market does appear to be pricing in near-term downside for equities. For support, consider options activity for the NASDAQ, which has been the leading market index this year. With the index hitting new highs, bets on a correction have soared, even after the index slipped a bit:

Source: Charles Schwab

My takeaway is that investors should take note of institutional activity here and plan accordingly. While one could take this as a contrarian indicator and increase their exposure, the size of the NASDAQ’s gain in 2020 has me reluctant to do so. The index is sitting well above pre-crisis levels, and the recent correction illustrated perfectly how quickly a winning trade can reverse. With the options market telling us to expect further losses, there is support for owning AGG at current levels to protect against that scenario materializing.

So, What’s The Problem? Part 1 – Declining Income

After laying out the merits to buying AGG, I need to highlight the risks. As I stated earlier, my outlook for AGG is muted, despite seeing it as a reasonable hedge against equities. The reason being both equities and bonds are pricey right now, so it leaves investors with few places to go for “value”. While AGG may hold up reasonably well if equities see a sharp sell-off, the upside potential is modest, in my opinion.

One reason for this thesis has to do with declining income offered by AGG. Now, this is not unique to AGG in relative terms, as most fixed-income sectors are struggling with the low rate environment. Refinancings in mortgages, corporates, and municipals all remain high, so fixed-income ETFs have to replace maturing/refinanced bonds with new issues at prevailing (lower) rates. This impacts the distributions these ETFs are able to offer, in a negative way. For example, AGG’s most recent distribution earlier this month is well below its level last year, as well as at the start of 2020, as shown in the chart below:

9/19 Distribution 9/20 Distribution YOY Change
$.263/share $.195/share (25.9%)
2/20 Distribution 9/20 Distribution YTD Change
$.243/share $.195/share (19.8%)

Source: iShares

Clearly, this is not a positive development for AGG investors. This marked decline in the distribution rate explains why the fund’s yield is just over 2.3%. While this still offers a decent spread over treasuries, given how low the Fed has pushed interest rates, it does not provide enough income to make-up for a meaningful drop in share price. If the market experiences a sell-off that drags aggregate bond funds down as well, this level of income will not provide much comfort, in my view. With interest rates unlikely to head higher any time soon, investors need to make sure this reality matches their expectations for AGG.

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So, What’s The Problem? Part 2 – Duration Risk

My next point expands on the declining income problem, with specific attention to how it correlates with duration risk. As I noted, AGG’s yield has declined, but its spread is still positive over treasuries. Therefore, investors may figure this yield is worth it, despite the declining distribution stream because it is difficult to get a better yield elsewhere without taking on a great deal more risk. While I generally concur with that sentiment, it is worth noting that investors are taking on more interest rate risk, as measured by the fund’s duration, for that smaller income stream.

To understand what I mean, consider that the fund’s effective duration has been rising over the past few years. This is because, as interest rates have declined, bond issuers are locking in lower rates for longer time periods. The net result for investors is that if interest rates do move higher in the future, funds like AGG will see their underlying bonds fall by greater amounts. Essentially, these bonds are more sensitive to interest rate movements because their terms are longer and their yields are lower. Simply, investors are tying up their money for a lower yield, which only makes sense if rates continue to stay low. Of course, this is the current expectation, so the duration risk is fairly modest in the short term. But it may have important implications over the longer term.

To understand why, consider AGG’s yield-to-maturity/duration ratio. This measures how much compensation (in yield) the fund is offering investors for the level of duration risk they are exposing themselves to. Not surprisingly, given the trends of 2020, this metric is at a decade-low, as shown below:

Source: Lord Abbett

The overall takeaway here is investors are being offered a historically low level of reward for the risk they are taking. This does not mean AGG is a “bad” investment, as I have already mentioned, it could still come in handy if equities drop. But it does support my view that upside is modest, as investors are taking on more downside risk than they might realize if they do not consider the yield offered versus the fund’s duration. This is a reason for my neutral view on AGG.

Higher Quality Holdings Than LQD

My final point looks at AGG, and why, despite my reservations, I may add some money to this fund. For fixed-income exposure, I lean heavily in the municipal bond space, via tax-exempt and taxable funds. However, I also prefer investment-grade corporate bonds, with a preference for the iShares iBoxx $ Investment Corporate Bond ETF (LQD). With a current yield at 2.87%, LQD offers a higher income stream compared to AGG, so it remains on my radar as a viable equity hedge as well.

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However, I do have some concerns with LQD, which is why I feel the AGG review is timely. The fund does offer a higher dividend yield, that is true, but that comes at a price. One of the key reasons for this higher yield is the make-up of the underlying holdings are noticeably different for investment-grade corporates in isolation, compared to an aggregate investment-grade fund.

To illustrate, let us look at AGG’s credit make-up, which shows a substantial amount of AAA-rated bonds, and small amount of BBB-rated bonds (the lowest investment-grade rating), as shown below:

Source: iShares

This is a result of AGG owning more treasuries and MBS assets, compared to corporate debt. For comparison, LQD, which is exclusively investment-grade corporate bonds, holds almost half of its assets in the BBB-rated category:

Source: iShares

This comparison shows how the investment-grade corporate bond sector has diverged from the total investment-grade bond market. With corporate debt issuance soaring, much of the issuance has fallen in the BBB-rated category. Now, this exposure does help an investor capture more yield, which is a positive. But it also exposes them to more credit risk for the privilege, compared to AGG. While investment-grade debt, even in the BBB-rated category, has a strong historical track record, investors will want to consider if the extra yield is worth going down the credit ladder. For me, I think both have a place, and I may use AGG to balance out my LQD position as a result.

Bottom-line

Equities have faced some pressure, and with limited Congressional action on stimulus, an upcoming presidential election, and persistent state lock-down measures across the country, I don’t see this changing before 2021. While I am not outright selling equities here, I am moving new cash in to selective fixed income positions, which puts AGG on my radar. With my muni and corporate bond positions already built up, I see merit to owning an aggregate bond fund for diversification. However, my outlook for AGG is modest, as I would be pleased to earn low single digits by year-end. Therefore, I view this as more of a protection against downside equity risk, rather than a way to earn meaningful returns. As such, I may build on a position of AGG, but I would encourage investors to approach new positions carefully at this time.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AGG over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long LQD



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