September 1, 2017— Under the staid surface of a low interest rate environment and a persistent tightening of credit premiums, much has changed in the composition of the U.S. bond market over the last 10 years. Investors need to take stock of these changes now before the next inevitable period of market turbulence catches them by surprise. Since the onset of the Great Recession, two major themes have taken place in the bond market with little notice or fanfare. First, issuers of all types have been extending their maturity profiles. So whether it is the U.S. Treasury or corporate America, more 10- and 30- year bonds have been brought to market amid strong investor demand. Second, the share of newly issued corporate bonds within the bond market has increased significantly.

During this historically low interest rate environment, the U.S. Treasury has extended its duration profile. As of June 30, 2017, the average maturity of U.S. marketable debt has extended to a record of 71 months, from 49 months in 2008. This represents a 45% increase. Additionally, U.S. Treasury Secretary Steven Mnuchin is advancing the prospect of issuing a 50-year bond, further increasing the duration profile of the overall U.S. Treasury market. The corporate sector has also seen an increase of 10-year and greater bond issuance since the Great Recession. Within the overall Bloomberg/Barclays Investment Grade Corporate Index, the number of bonds with maturities fewer than eight years has declined from 62% in 2006 to 55% in 2017. Over the same time period, bonds with maturities greater than eight years have increased from 38% to 45%. 

 Figure 1

Market value weighting of investment-grade index

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Source: Bloomberg/Barclays

The Bloomberg Barclays Aggregate Bond Index represents, as its name implies, the complete investment-grade bond market universe. Bonds within the index include U.S. Treasuries, corporates, asset-backed securities, and various types of mortgage-backed securities. The maturity spectrum of bonds within the index ranges from one to thirty years.

The overall duration of the Aggregate Index has increased from 4.54 to 5.82, an extension of 30%. Ten years ago, if interest rates rose by 100 basis points (1.00%) instantaneously, investors mirroring the Aggregate Index would have expected a 4.54% loss. Ten years later, that loss would be 5.82%.

The amount of credit within the Aggregate has also grown from 22% in 2006 to 30% today. Meanwhile, higher bank capital standards, put back risk (banks on the hook for poorly originated mortgages), and a much smaller FNMA (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation)  presence, have led to a decline in mortgage-backed  and U.S. government agency securities. Within the credit universe, the industrial sector has increased the most, moving from 9% of the overall index to 15%. Dissecting the index further reveals that the number of BBB-rated corporates has risen to 14% from 8% of the overall index. Most of the increase in BBB-rated securities came at the expense of the AAA category, as U.S. government agencies have issued less debt. 

Today the index has 30% more overall interest rate risk, 35% more corporate risk, and 75% more BBB-rated securities now versus 10 years ago.  

Figure 2

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Source: Bloomberg/Barclays

It should be noted that while we have focused on the Aggregate Index because of its universality, almost all of the longer-term Bloomberg/Barclays Indices have changed in a similar fashion. The Bloomberg/Barclays Government Credit and the Intermediate Term Indices have seen similar duration extensions and added corporate risk. In addition, bond indices from other sources, such as Bank of America, have also seen durations and corporate exposures increase.

These changes to the Index have definitely benefited investors over the past 10 years, as interest rates have fallen and credit spreads have compressed. However, investors should take note of the changes in the Index and the inherent added risk that they have taken on since the Great Recession. 

Another significant change to the U.S. bond market over the last 10 years has been the composition of investors. As Figure 3 illustrates, in 2007, 71% of U.S. corporate bond ownership was in the hands of domestic institutional investors. Today that percentage has fallen to 50%. Life insurance investors and other segments of the institutional bond market typically hold their bond positions for long periods of time if not until maturity. Over the same time period, the share of non-U.S. investors of corporate bonds has increased from 25% to 40%. It is unclear how stable this investor base will prove to be. However, most of the increase is due to the fact that European and Asian investors facing very low if not actual negative interest rates in their local markets have been forced to look abroad to achieve higher yields. Given the added foreign exchange risk that is inherent to this investor base, common sense suggests that their ongoing sponsorship to U.S. corporate bonds will be more volatile. 

Figure 3

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Source: Wells Fargo

Core narrative

As credit premiums have compressed significantly, we continue to expect corporates to offer better risk adjusted returns than U.S. Treasuries. The time to pivot from an overweight allocation to corporates is perhaps close at hand. The current U.S. economic expansion is already the third longest in the country’s history. The Federal Reserve is expected to continue to tighten monetary policy. And perhaps most importantly, the political reality of continued congressional gridlock with a Republican- controlled Congress and White House make fiscal and taxation remedies to boost U.S. economic growth seem delayed and watered down at best. Investors with a passive investment approach to bonds should take a discerning look at their portfolios and their appropriate relevant index. Pre-2007 index performance may prove to be significantly different in the future given the changes we have outlined. 

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