Changing Composition of the Barcap Agg?

June 23, 2011

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33% (see first image above – click on thumbnail for larger version). This highlights a drawback of any bond benchmark based on issuance. Issuance based benchmarks by their nature drive allocations not based on expected risk and return, but based on the funding needs of underlying issuers. One of the primary drivers of the increase in treasuries as a percentage of the Agg has been the large federal deficits caused by the 2008 recession necessitating higher treasury issuance. Historical and projected deficits are shown in the second image above (click thumbnail for larger version).

The federal deficit picture shows why the Treasury component of the Agg may stabilize, albeit at a higher level. While the Federal budget remains challenged and the political environment uncertain, through GDP growth alone the Federal deficit will decrease from its peak.

A more important concern for investors is how the change in the composition of the Agg affects the risk and return profile of their fixed income portfolios. If treasuries increased in market weighting in the Agg, clearly other sectors decreased in weighting. The change in sector weighting in the Agg for major sectors is shown below:

	Treasury	Credit	MBS	Agency	Securitized
Chg. In Mkt	11.02%	1.16%	-6.49%	-2.59%	-3.10%

Source: Barcap; changes since December 2008

As treasuries have increased as a percentage of the Agg, MBS, agency bonds, and securitized products (ABS and CMBS) have decreased. This is due to a combination of decreases in issuance, especially for securitized products, and Fed purchases (MBS). Notably, the percentage weight to corporate bonds has remained constant on relatively strong issuance, and the weight to credit as a whole has actually increased.

Over the past 10 years, treasuries have been highly correlated with agencies (0.96) and MBS (0.85), and had a lower correlation with credit (0.62). Returns and standard deviations for the past ten years are shown below:

	Return	Stdev
Treasury	5.54%	5.09%
Agency	5.36%	3.68%
MBS	5.81%	2.81%
Credit	6.48%	5.85%

If these relative trends continue, and the sector allocation of the Agg continues to have a higher percentage of treasuries passive investors in the Agg will likely not see much difference in expected future returns. However, passive investors will likely see an increase in future volatility, as the standard deviation of treasuries has been much higher than the standard deviation for agencies and MBS. Investors in active core fixed managers are unlikely to experience changes in expectations due to the changing composition of the Agg, as active managers are often perpetually underweight treasuries.