If you think volatility is only something stock market investors need to worry about … you may want to think again. Just take a look at the graph below of 10-Year US Treasury yields, and you’ll recognize the roller-coaster ride that government bonds have been on since 2008.¹

As recently as the end of July, 10-year Treasury yields were above 3 percent. Then Standard & Poor’s downgraded the US government’s credit rating. And, perhaps contrary to most expectations, government bond prices soared, pushing yields on the 10-year Treasury briefly below 2 percent last week.²

That’s a 30 percent swing in yields over a period of just a few weeks — a monster move for bond markets.

It seems to defy logic why US interest rates would go down in response to Uncle Sam’s lowered credit rating. After all, if you are judged to be a greater credit risk, your borrowing costs should go up, not down. However, we see some other factors at work here.

First, US economic data slowed noticeably around the same time as the S&P downgrade. On July 29, US gross domestic product (GDP) was revised sharply lower for the first half of 2011. A soft economy often brings a “flight-to-quality” reaction from investors seeking the relative safety of government bonds.

Second, the Eurozone debt crisis was also in the process of going from bad to worse at the same time. This may have triggered a “flight-to-safety” move by global investors out of European bonds and into US Treasuries.

Third, by this point, the debt downgrade may have already been priced into US Treasury bond markets. After all, the folks at S&P had telegraphed the possibility of a rating change well ahead of the actual announcement. Remember, buy the rumor … sell the news!

For all of these reasons and then some, investors viewed US Treasury bonds (and gold) as perhaps a safe haven, at least on a relative basis, amid so much uncertainty. We believe this helped produce the extreme volatility in government bond markets, with 10-year yields falling to historic lows.

What’s in a Benchmark?

At Banyan Partners, we invest our clients' portfolios with a long-term view but manage proactively. Right now, we’re not big fans of long-dated US Treasury bonds. With yields starting from such historically low levels today, we don’t see much upside potential … but there’s still plenty of downside risk when interest rates and inflation eventually move up.

Meanwhile, in the aftermath of the financial crisis, the fundamental makeup of the bond market has shifted. Old assumptions about risk and return characteristics of various types of bonds are changing, as we pointed out in a recent issue of the Banyan Market Letter (Issue 28 • August 3, 2011).

However, the changes happening in the bond market aren’t reflected by its most popular benchmark. And if you invest in bond mutual funds that track this index, you may not be properly diversified.

Many fixed income mutual funds (and ETFs) are benchmarked against the Barclays Capital US Aggregate Index — or the “AGG” as it’s known. It can be said that the AGG is to bond funds what the S&P 500 Index is to equity mutual funds — the standard against which all are measured.³

The trouble is investors may not be aware that this index is not a perfect representation of today’s changing global bond markets. For example, the AGG isn’t particularly well-diversified in the sectors of the bond market where Banyan is finding some of the best opportunities today. Let’s take a closer look.

The AGG is limited to investment grade bonds (rated from BBB to AAA by S&P) and is further limited to only US dollar-denominated bonds.

As you can see in the graph at right, the biggest weighting in the index by far at 36 percent is US mortgage and asset backed securities. Next come US Treasuries at 33 percent, followed by government agency debt at 12 percent of the index. Corporate bonds account for only 19 percent of the AGG’s asset allocation.⁴

And there is only a small weighting in foreign bonds, even though there are 19 other nations that now have higher credit ratings than the USA, at least according to S&P.⁵

At Banyan, we believe there is a disconnect when using this popular index as a “typical” fixed income benchmark for several reasons.

#1: Too Much US Government Debt. There’s little difference today between Uncle Sam’s “explicit guarantee” on US Treasuries, and its “implicit backing” of government agency debt, and mortgage backed securities. Since the financial crisis, they’ve all been pretty much lumped together. Fannie Mae and Freddie Mac issue mortgage backed securities, and these entities have been under US government conservatorship since they were bailed out a few years ago.

Fannie and Freddie were also downgraded by S&P recently, along with 10 Federal Home Loan Banks across the US. Why? Because they are now entirely dependent on Uncle Sam’s credit rating … the same as newly issued US Treasuries.⁶

Look back at AGG’s asset allocation, add up the components, and you’ll see that 81 percent of this index is invested in securities backed in one way or another by Uncle Sam. This bond index is not as diversified as you might think.   

#2: Not Enough Corporate, International Bonds. Through the end of last week, the AGG has gained 4.6 percent over the past 12 months. But the Global Aggregate Bond Index is up 8.8 percent … and the US Corporate High Yield Bond Index has gained 7.1 percent. Today, there is a wide world of opportunity for investors to explore other fixed income sectors, outside of US Treasury and agency securities.⁷

Many countries and regions of the world enjoy not only a higher credit rating than the US, but also stronger economic growth prospects. Some global bond markets offer substantially higher yields too. Of course, international bond markets aren’t immune to global volatility and carry some unique risks (political, accounting, currency), but a well-diversified bond portfolio that includes even a small allocation to international bonds has the potential to enhance your overall returns.

When it comes to US corporate bonds, we’re also finding attractive opportunities in short- to intermediate corporate bonds of many high-quality US firms. After paying down debt in recent years, US corporate balance sheets are in great shape today, with companies sitting on nearly $2 trillion in cash!⁸

As we said in a previous issue (Issue 28 • August 3, 2011), “the creditworthiness of government versus corporate debt appears to be trading places,” to some degree.

In many cases, we’ve already done our homework on the common stocks of blue-chip companies, including AT&T and General Electric, for instance. And if we’re comfortable owning these stocks for our clients, we’re even more confident owning the short-term corporate credit of these same firms. In our Banyan custom fixed income portfolios, our weighted average maturity in corporate bonds is just over 3 years, with an average current yield of 5 percent.

When it comes to stocks, blindly following an index like the S&P 500 hasn’t worked very well in recent years. Popular bond market indexes can likewise be subject to similar faults and may not be as diversified across different sectors of the fixed income markets as you think.

The lesson: Understand what you own, and if your plain-vanilla bond fund (or ETF) is specifically invested to track the Barclays US Aggregate Index, you may be more concentrated in US government debt than you realize. Your performance may be okay during turbulent market conditions as we’ve seen recently, but why invest in an index fund when you can customize your fixed income portfolio by picking and choosing among the best bond market opportunities?

That’s the goal of our fixed income portfolios at Banyan. Following a more customized approach to your investing can result in greater diversification and may be better suited for changing bond market conditions over the long run.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. For more information about Banyan’s custom fixed income portfolios and where we’re finding opportunities in today’s market, go here now.

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¹ Bloomberg market data, 8/29/11
² Ibid.
³ State Street Global Advisors, 3/31/11
⁴ Ibid.
⁵ Ibid.
⁶ Fidelity Viewpoints, 8/13/11
⁷ First Trust Market Watch, 8/29/11
⁸ Fidelity Viewpoints, 8/13/11