Fed rate hike: The case for the Barclays Agg

Dec 17, 2015 / by Anne Ackerley

After months of speculation, on December 16, the Fed announced its first rate increase in nearly a decade. While this move is small (and we expect additional modest increases over an extended period), now that it is a reality, defined contribution plan sponsors may be asking if the time has come to reconsider bond exposures that track the Barclays Aggregate Index.

The “Barclays Agg”, as it is commonly called, is the most widely used barometer of the U.S. bond market and reflects significant interest rate risk. Even modest rate increases will likely cause bond funds based on this index to lose value. But that does not mean that it’s automatically time to seek out other fixed income strategies.

That decision depends on the role the bond exposure is intended to fill on an investment menu. Take for example, the role of bonds in a commonly used DC investment option: the target date fund. While the bond exposure may contribute to the fund’s total return, its primary purpose is to help diversify against equity risk. And that is a particularly important consideration in today’s volatile markets. Let’s explore this more deeply below.

Here’s the big question: In a rising rate environment, should target date funds stay the course and keep their exposure to the Barclays Agg? We believe the answer is yes.

Target date fund vs. standalone options: The fixed income difference

There are two main reasons to hold bond funds. The first is to serve as a standalone solution that participants select on their own. Here, the role of a bond option may be to provide returns or income. If this is the goal, you may not need to step away from the Barclays Agg completely, however, it may make sense to employ solutions that also increase exposure to credit and other economic risks in order to generate returns in a changing fixed income landscape.

The second reason to invest in bonds – in fact, the reason they are typically used in target date funds -- is to help diversify equity exposure. If the equity market sees a steep sell-off, bonds are expected to continue playing their traditional role by increasing in value, thereby offsetting some of the market shock. (In 2008, for example, the S&P 500 Index fell 37% and the Barclays Agg rose over 5%.*)

So here’s the big question: In a rising rate environment, should target date funds stay the course and keep their exposure to the Barclays Agg?

We believe the answer is yes. The Barclays Agg remains an effective equity hedge, especially critical to its role in a target date fund. What’s more, many of the strategies that may be appropriate for improving the return potential of standalone bond funds may be counterproductive in a target date fund because they would reduce the bond exposure’s ability to diversify equity risk. Here are two examples:

  1. Shortening duration: While shortening duration may reduce the impact of rate increases, it doesn’t come without a cost. It may mean giving up some yield, which can detract from the fund’s total return. More importantly, it could reduce the bond allocation’s hedging properties. And in a scenario where short term rates rise but longer term rates do not move, you may be giving up equity risk protection without improving the bond sleeve’s performance.
  2. Increasing flexibility: Managing to new benchmarks, such as the Barclays US Core Fixed Income Balanced Risk, may help balance credit and rate risk. But increasing exposure to credit or economic risk factors may make the bond fund more highly correlated with the equity allocation – precisely the opposite of its goal within a target date fund.

Bottom line: Know your fixed income goal

The role of a target date fund manager is to meet the fund’s overall objective. If equity diversification is part of that objective, the Barclays Agg remains an appropriate choice even in the face of the new rate increase. That may change in the future as the fixed income market evolves, but our advice is to carefully consider your fixed income goal before exploring the alternatives.

*Source: Morningstar

Anne Ackerley
Managing Director, Head of BlackRock's U.S. and Canada Defined Contribution Group
Anne F. Ackerley, Managing Director, is head of BlackRock's U.S. & Canada Defined Contribution (USDC) Group. She is responsible for the development and ...