Young, inexperienced investors often receive the same advice: just buy the market.
In fact, market luminaries from Warren Buffett down have advised young people looking to accumulate long-term wealth to own low-cost mutual funds and exchange-traded funds that track broad stock indexes.
The idea here is simple. Owning a broad range of the stock market reduces the likelihood that a decline in a single stock will negatively impact your portfolio’s performance. Additionally, owning a fund that tracks a major index can theoretically benefit from the stock market’s historic upward trajectory and avoid the temptation to beat a market that is difficult for even professional investors.
The most popular broad stock market proxy for retail investors is the S&P 500, with each of the market’s three largest ETFs tracking it, according to ETF Database.
But how does “just buy on the market” apply to you if you want to own bonds?The go-to index for bond investors is the Bloomberg U.S. Aggregate Bond Index, also known as Agg. Similar to the S&P 500, you can purchase funds that track the index directly.
But those looking for bond exposure should think twice before making Agg funds their only bond holdings, says Steve Raipley, global co-head of the iShares fixed income ETF. When considering adding such funds, “we need to consider what investors are trying to do.”
The case for owning Agg
Some young long-term investors ignore bonds altogether. These IOUs tend to have lower returns than stocks over the long term. Bonds are also much less volatile than stocks and tend to fluctuate based on various market forces, so bonds may retain their value or provide positive returns even when stocks decline.
That’s why they’re a staple of more conservative portfolios aimed at preserving wealth rather than growing it. These qualities can make bonds attractive to risk-averse investors or those saving for short- to medium-term goals, such as buying a home, experts say.
Mark McCarron, chief investment officer at Wescott Financial Advisory Group, says if you’re looking to add bond holdings to reduce volatility in your portfolio, you could do a lot worse than adding an Agg fund.
“Its role in your portfolio is a hedge against recession, and it’s a diverse mix of Treasuries, investment-grade corporate bonds and securitized bonds. So buy it,” he advises clients looking for core fixed-income holdings.
In other words, Agg holds a variety of debt obligations, including government bonds, that have a relatively low probability of default. You then follow the same logic of owning the S&P 500, effectively spreading your stake across a variety of investments.
understand the risks
If you’re holding a bond fund to preserve the value of your portfolio in the short term, it’s worth being aware of some of the risks associated with Agg and bond funds.
Agg invests heavily in U.S. Treasuries and other types of investment-grade bonds, meaning credit risk, or the risk that the issuer will default and investors are left holding the bag, is relatively low.
Agg currently leans heavily toward U.S. Treasuries, with government-backed bonds accounting for 46% of the index. Nick Lloyd, vice president at asset management firm Novare Capital Management, said investors in these debt instruments take little risk (backed by Uncle Sam, who has never defaulted), so they pay out very little.
Agg’s increased investment in U.S. Treasuries in recent years has given it “more opportunity to consistently hold the lowest-yielding fixed income products,” he said. “This is considered a risk-free rate.”
Investors looking to get more out of their bond investments could therefore consider owning a broader slice of the bond market, including lower-rated bonds, or a fund with a more favorable mix of corporate debt, he says.
Conversely, Agg owners should pay attention to interest rate risk, Lloyd says. Agg’s duration (a measure of interest rate sensitivity) is currently 5.7 years. This means that if interest rates rise by 1 percentage point, a fund that tracks the index will fall by 5.7%.
This risk is especially important for bond investors these days. As of Tuesday, traders believed there was an 87% chance the Federal Reserve would raise rates by at least one quarter point by the end of the year, according to CME’s FedWatch tool, which tracks market expectations for interest rate decisions.
Experts recommend consulting a financial professional before making any adjustments to your portfolio based on changes in interest rates. After discussing your goals, you may want to hold an Agg fund alongside other bond funds to reduce overall interest rate sensitivity or hedge against inflation.
No matter how you put together your bond portfolio, it’s wise to do so in a broadly diversified way, says Raipuri.
“The key is to diversify your income sources and really understand their risk profile.”
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