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Young and inexperienced investors often find themselves receiving some version of the same advice: just buy the market.
Indeed, market luminaries from Warren Buffett on down advise that young people looking to accumulate long-term wealth should own low-cost mutual funds or exchange-traded funds that track a broad stock market index.
The thinking here is straightforward: By owning a large swath of the stock market, you lower the odds that a slide in any one single stock could ding your portfolio’s performance. Plus, in owning a fund that tracks a major index, you theoretically benefit from the stock market’s historical upward trajectory and avoid the temptation to try to beat the market, which even professional investors have a tough time doing.
For retail investors, the most popular broad stock market proxy is the S&P 500, with the three largest ETFs on the market each tracking the index, according to ETF Database.
But how does “just buy the market” apply if you want to hold bonds? For fixed income investors, the flagship index is the Bloomberg U.S. Aggregate Bond Index, also known as the Agg. As with the S&P 500, you can buy funds that track the index directly.
But those looking for bond exposure should think twice before making an Agg fund their one and only bond holding, says Steve Laipply, global co-head of iShares Fixed Income ETFs. Any consideration of adding such a fund “needs to be in the context of what an investor is trying to do.”
The case for owning the Agg
Some younger long-term investors ignore bonds altogether. These IOUs tend to offer lower returns than stocks over time. They also tend to be far less volatile than stocks and move based on different market forces, meaning that bonds can retain their value or even deliver positive returns when stocks sink.
That’s why they’re a staple in more conservative portfolios aimed at preserving rather than growing wealth. Those qualities might make bonds attractive to risk-averse investors or those saving for a short- to intermediate-term goal, such as buying a house, experts say.
If you’re looking to add a bond holding to tamp down on volatility in your portfolio, you can do far worse than adding an Agg fund, says Mark McCarron, chief investment officer with Wescott Financial Advisory Group.
“Its role in the portfolio is to hedge some against recession, and it’s got a diversified mix of Treasurys and investment-grade corporate bonds and securitized bonds. So just buy that,” he tells clients looking for a core bond holding.
In other words, the Agg holds a mix of debt — including Treasurys — that is relatively unlikely to default. And, following the same logic as holding the S&P 500, you’re effectively spreading your bets across a wide variety of investments.
Understand the risks
If you’re holding a bond fund to preserve the value of your portfolio over the short term, it’s worth noting some of the risks that come with the Agg, or any bond fund.
The Agg is invested heavily in Treasurys and other types of investment-grade debt, meaning that it carries relatively low credit risk — the risk that an issuer will default on the debt, leaving the investor holding the bag.
The Agg is currently tilted heavily toward Treasurys, with the government-backed bonds accounting for 46% of the index. Because investors in these IOUs take such little risk (they’re backed by Uncle Sam, who has never defaulted), they come with a paltry payout, notes Nick Lloyd, vice president at wealth management firm Novare Capital Management.
With the Agg becoming more heavily invested in Treasurys in recent years, “you’re consistently owning more and more of the lowest yielding fixed income instrument,” he says. “It’s considered the risk-free rate.”
Thus, investors interested in earning more on their bond investment could consider owning a wider swath of the bond market that includes lower-rated debt, or a fund with a mix that favors more corporate IOUs, he says.
Conversely, owners of the Agg should keep an eye on interest rate risk, Lloyd says. The Agg currently carries a duration — a measure of interest rate sensitivity — of 5.7 years, meaning that any fund tracking the index would decline by 5.7% in response to a 1-percentage-point uptick in interest rates.
That risk is of particular importance to bond investors of late. As of Tuesday, traders see an 87% chance that the Federal Reserve hikes interest rates by at least one quarter point by year-end, according to CME’s FedWatch tool, which tracks market expectations for rate decisions.
Experts recommend talking with a financial professional before making any adjustments to your portfolio based on moves in interest rates. You may find that, after discussing your goals, you want to hold an Agg fund alongside other bond funds that lower your overall interest rate sensitivity or even hedge against inflation.
No matter how you put your bond portfolio together, you’d be wise to do it in a broadly diversified way, says Laipply.
“It’s really about diversifying your sources of income and really understanding the risk profile of that.”
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