AGG: I Hate Bonds – Here’s Why You Want Them In Your Portfolio

(This article was co-produced with Hoya Capital Real Estate.)

There, I said it. I hate bonds.

In this, you and I are likely aligned. We’ve all likely read all the same arguments. It’s true, bond yields are low at the moment. And yes, inflation and rising interest rates pose a challenge.

Even worse, if one does not understand what one owns when it comes to bonds, there can be some nasty surprises along the way.

Using my real name, not my ETF Monkey pseudonym, I happen to belong to a Facebook group named Friends of Vanguard. I find it helpful reading the posts in that group because they come from a variety of investors; from those brand new to investing all the way to seasoned veterans.

Here is a sample, from one reader who expressed a level of dismay over the performance of bonds.

So I finally got convinced to do an 85/15 “bond mix” in late-2020 instead of all stock. It has cost me quite a bit . . . is there a better bond fund out there to use? Not sure why I picked this one at the time, but I would have been better off holding cash.”

As it turns out, this investor had selected a mutual fund, Vanguard Long-Term Treasury Fund Investor Shares (VUSTX) for his investment. For ETF Monkey readers, this mutual fund roughly equates to iShares 20+ Year Treasury Bond ETF (TLT), which I have covered in some depth here, as well as including in the ETF Reliable Retirement Portfolio.

I won’t go to all the trouble to create a specific graph for this, but suffice it to say that it is absolutely the case that both VUSTX and TLT have experienced declines over that specific time frame. In late-2020, long interest rates were very close to their all-time lows, and have risen since that time. Additionally, since interest rate movements have outsized effects on longer-term bonds, the price of these instruments has suffered a decline of roughly 10% over the span in question.

As it happens, from a pure timing standpoint, our investor purchased perhaps one of the worst-performing bond funds over this particular time frame. With an experience like that, is it surprising a level of dismay exists?

Stepping Back To See A Bigger Picture

So what can we say? Shall this bad experience completely sour us on bonds and the idea of including these in our portfolio? And what about the fact that, while there may be disagreement on the ultimate extent, it is almost certain that interest rates are heading north from here?

To gain a little perspective, I asked myself the question “Can I look to a recent period where interest rates rose over a reasonably sustained period of time, and see how bonds performed?”

And so I did. Below, I have captured two graphics from the FRED website. They both cover the period from January 2014 – December 2019.

Our first graphic features the Federal Funds Effective Rate, the interest rate that depository institutions – banks, savings and loans, and credit unions – charge each other for overnight loans. The second graphic features the discount rate, the interest rate that Federal Reserve Banks charge when they make collateralized loans – usually overnight – to depository institutions.

As can be seen, both interest rates rose roughly 2.5% over that span. For purposes of the next comparison I will present, we are going to select a slightly tighter time span within the above range. Specifically, the span from 2015-2018. If you look closely at the above graphics, you will see that all the interest rate increases took place within this shorter time span.

Here, then, is a backtest from Portfolio Visualizer, covering that 4-year period of steadily rising interest rates. Basically, I used iShares Core S&P 500 ETF (IVV) as my proxy for the S&P 500. I then mixed in an allocation of first 20%, and then 40% in bonds, using iShares Core U.S. Aggregate Bond ETF (AGG), the subject of this article, along with Vanguard Short-Term Bond ETF (BSV) and, in one comparison, even threw in some TLT for good measure. Remember, long-term bonds are particularly sensitive to rising rates.

Take a quick peek at the weightings, and then we’ll look at the results.

In the results below, I added the Vanguard 500 Index Investor index as my benchmark. This allowed me to use various IVV/bond weightings for the comparison test.

As can be seen, the Vanguard 500 Index Investor index, the equivalent of a 100% IVV portfolio, performed the best in terms of absolute return. But take a look at the various bond allocations. In each case, the Sharpe and Sortino ratios, measures of risk-adjusted returns, are higher. Perhaps very counterintuitively, the portfolio including a measure of TLT performed the best of all, on a risk-adjusted basis.

Back to my title. Yes, I hate bonds right here. And likely, so do you. But I hope the material above may help in understanding why it is beneficial to at least have some allocation to these in your portfolio.

iShares AGG – Digging In

iShares Core Aggregate Bond ETF is one of the very best tools on the market with which to establish, and maintain, an allocation to bonds. The word “core” is embedded in its name, and this is no misnomer.

AGG seeks to track the Bloomberg Barclays U.S. Aggregate Bond Index, which includes taxable, investment-grade U.S.-dollar-denominated bonds with at least one year until maturity. With an inception date of 09/22/2003, AGG is now well into its 19th year. As of this writing, its AUM sits at roughly $90.81 billion. It carries an expense ratio of .04%, and also boasts a tiny .01% trading spread.

Take a look at the below chart from Seeking Alpha. Before we go any further, let me point out one thing. If, instead of the 5Y button selected below, you had clicked on the 1Y button, you would have seen a return of -4.28%. If you just look at the graphic, you can see that this would be the case. At the same time, the 5Y return displays as positive.

If you trace that line backwards, you will also see that, were you to add a little AGG today, you would be doing so right around the low of the past 3 years.

Digging a little further into the information offered on Seeking Alpha, we see why AGG qualifies as a core bond holding. It spans the gamut of government and corporate bonds.

Moving next to iShares’ own supplementary material, we can dive even a little deeper into the breakdown of AGG, as of December 31, 2021.

One number to note in the lower-left corner of the graphic is AGG’s effective duration. For those unfamiliar with the meaning of duration, take a look at this article at your convenience. In brief, though, let me piece it together for you.

In the upper-right-hand corner of the graphic, note that AGG’s three largest maturity concentrations are in the 3-10 year range. Smaller percentages are below and above this range. Looking back at the lower-left corner, that weighted average maturity of 8.51 years likely makes more sense to you. The difference between that and the effective duration of 6.64 years is that you don’t have to wait until maturity to get your full investment back. The lower number reflects the fact that you are receiving, in the case of AGG, monthly interest distributions along the way.

The benefit? You are receiving regular cash flow, which both helps to stabilize your portfolio as well as providing funds for reinvestment, whether in bonds or some other asset class.

Summary and Conclusion

In this article, I have argued that, despite their current low yields, and even factoring in the threat of rising interest rates, bonds deserve at least some place in your portfolio. Even during periods of rising interest rates, they provide a measure of stability as well as a source of income.

They also offer an additional benefit. While it is tempting to look at the superior absolute returns of a portfolio comprised of 100% stocks, the simple fact is that volatility, combined with human emotion, can also lead individuals to do exactly the wrong thing at the wrong time. Might it be the case that, at times such as exactly what we have seen this past month, the balancing influence of bonds might save you from emotional mistakes (as Larry Swedroe refers to it, the “Get Me Out!” emotion) and foster more rational decisions?

Only you can decide. As you do, I hope the information provided herein has been of some use.

As always, until next time, I wish you . . .

Happy investing!!