Since the financial crisis, government policy and direct issuance of Treasury securities have resulted in increased duration and lower yields in the Barclays U.S. Aggregate Index. These changes pose a direct challenge to investors in bond index funds, which are fully exposed to the concentrated risks that are now embedded in the index. Modest return expectations and the prospect for higher interest rates favor active management, which provides investors with the benefits of core bonds while potentially mitigating risk and earning higher returns.
The combination of duration and yield in a core bond portfolio generally functions as the primary diversifier to equity exposure. Core bonds continue to play a key role in portfolio risk management and asset allocation.
Duration on the U.S. Aggregate increased from 3.7 years at the end of 2008, as the financial crisis peaked, to 5.6 years currently; yield-to-maturity fell from 4% at the end of 2008 to 2.2% currently. In another word, the yield per unit of duration has decreased from 1.1 to 0.4 over the past six years, so using a core bond index fund today exposes portfolios to greater interest rate risk with limited compensation in the form of yield.
Since the 2008, many companies have used bond proceeds to buy back shares, which altered the firms’ capital structures and, in a number of cases, increased their leverage. Taken together, this means that index investors have assumed greater exposure to more levered companies, highlighting the need for an active credit-review process. The average credit quality of the corporate bond component in the Aggregate index has slipped from A2/A3 to A3/Baa1 as the proportion of Baa rated bonds has increased.
Skilled managers seek to mitigate outsize or poorly compensated risk within the benchmark while identifying pockets of value. In addition, active managers have the ability to employ investments outside the benchmark that can enhance diversification and return potential.
Given that the duration of the U.S. Aggregate is near all-time highs, risk management in core bonds is paramount. In addition, in the current low-return environment, the excess returns generated by skilled active managers contribute a larger proportion of total portfolio return.
 Data source: Barclays