Fixed income investments offer income, diversification and stability, playing a crucial role in many individual portfolios. Conservative and retired investors should allocate at least a portion of long-term savings in fixed income securities. Bonds, especially government-issued securities, are seen as a safe haven during volatile periods when investors behave more emotionally than rationally and may move inversely with stocks.
AGG has over $30 billion in assets, which has attracted competition. The latest offering aiming for a slice of AGG’s market is WisdomTree’s Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY). This new addition to the ETF space is an interesting option that warrants comparison to its larger, more established competitor.
iShares Core U.S. Aggregate Bond (AGG)
A popular investment choice for bond exposure is the three-star Morningstar-rated iShares Core U.S. Aggregate Bond (AGG). This single ETF provides low-cost, broadly diversified exposure to the U.S. investment-grade bond market. As of January 2016, AGG had $31.7 billion in assets under management. The fund seeks to track the performance results of the Barclays U.S. Aggregate Bond Index, which includes U.S. Treasury bonds, government-related bonds and mortgage-backed securities as well as corporate bonds, asset-backed securities and commercial mortgage-backed securities. This index is widely accepted as the benchmark for the U.S. investment-grade bond market, and many “total” or “aggregate” bond funds use it as their benchmark.
AGG invests 90 percent of its assets in bonds contained within the underlying index; however, it utilizes a sampling strategy to engage and considers transaction costs and tax efficiencies when attempting to closely replicate the performance of the underlying index. While the benchmark contains approximately 10,000 individual bonds, AGG holds only 5,000. The fund rebalances monthly and currently is slightly overweight U.S. Treasuries and Agency debt.
The fund spreads its holdings across a broad spectrum of maturities, resulting in an average weighted maturity of 7.3 years. It has an effective duration of 5.1 years. If interest rates either rise or fall by 1 percent, the price of AGG would be expected to deviate by about 5.1 percent. As a result, AGG has a fairly moderate inflation risk. AGG has an average credit quality of AA and an average weighted coupon of 3.23 percent.
AGG has tracked the performance of its benchmark closely, while charging only 0.08 percent, which includes a 0.01 percent expense waiver that expires in June 2016. Over the trailing three-, five-[ALDM1] and ten-year periods, AGG has trailed the performance of the index by 0.04, 0.10 and 0.16 percent, respectively, which confirms that the fund’s expense ratio accounts for most of the tracking error.
WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY)
Many investors are concerned about rising interest rates and inflation, which could impact investment yields. Investors have relied on core bond holdings to mitigate volatility and generate income, but U.S. Treasuries hover near historic low yields. High-yield funds face added risk and volatility. As a result of falling yields, the income generated by AGG has fallen as well. WisdomTree is looking to attract those income-oriented investors looking for additional yield with the WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY).
This relatively new fund, established in July 2015, provides the potential for enhanced income while continuing to benefit from a single low-cost option that offers broad diversification. AGGY tracks the Barclays U.S. Aggregate Enhanced Yield Index, which tweaks the Aggregate Index followed by AGG. Utilizing a rules-based approach, AGGY shifts exposure across levels of interest rate and credit risks as well as across various market sectors to increase yields.
Given current conditions, AGGY will typically overweight corporate credit while underweighting Treasuries. The fund’s relative position in mortgage-backed securities may fluctuate given market conditions. This is the opposite of AGG, which tends to consistently invest heavily in Treasuries and mortgage-backed securities due to their relatively large share of the total bond market. The result is a declining yield for AGG but a higher return for AGGY.
The Enhanced Yield Index retains the broad risk characteristics of AGG while reassembling the index’s 20 subcomponents, which reflect a combination of bond types, credit quality and maturity. The index will reallocate assets within and across these subcategories in order to deliver a higher yield.
There are some limits on the ability of AGGY to increase yield. The duration of AGGY cannot be more than one year longer than that of the AGG index. The relative weights of the various subcategories will not deviate more than 20 percent from similar subcategories contained in the comparable AGG. The fund is rebalanced by a maximum of 5 percent each month to ensure that it stays within these risk constraints. If necessary, the turnover percentage will increase by 1 percent increments until the correct weightings are achieved.
The result is a substantially different portfolio in terms of the subcomponents. Recently, AGGY held 18 percent of assets in U.S. Treasury bonds, versus 39 percent in AGG. Corporate bonds were 46 percent of assets, compared with about 24 percent in AGG. These two divergences were the main difference between the two funds and resulted in a distribution yield of about 2.9 percent for AGGY versus 2.5 percent for AGG, or a 16 percent improvement. The gap has been wider at times. As of the end of December 2015, AGGY delivered an additional 79 basis points of yield compared with AGG.
While holding fewer Treasuries in AGGY helped boost its yield, the fund’s smaller Treasury bond position caused it to underperform slightly during the Treasury rally these past couple of months. As of February 15, AGGY gained 1.41 percent in 2016 versus AGG’s 1.59 percent.
AGGY is designed to deliver higher income, not beat the market in all conditions. Investors seeking total return may want to seek out a bond fund that has capital appreciation as one of its mandates. Additionally, , at 0.12 percent of assets, AGGY costs slightly more than AGG. If the strategy delivers over the long term, the increased yield will more than offset the increased fees. This is a hefty risk, however, given the short period of time the fund has been in existence. We are intrigued by AGGY, but nevertheless we shall await a more complete track record. Currently, we have issued a Buy recommendation for AGG and a Hold recommendation for AGGY. This could quickly change as we review relative performance over the coming months.