Bond index funds may not offer a complete fixed income allocation

Investors using broad index funds for bond exposure face a different set of trade-offs than those buying broad equity benchmarks, advisers told CNBC. Funds tied to the Bloomberg U.S. Aggregate Bond Index offer diversified investment-grade debt exposure, but the index’s current Treasury weight and interest-rate sensitivity can shape returns in ways investors may not expect.

The Bloomberg U.S. Aggregate Bond Index, widely known as the Agg, is the main U.S. benchmark for high-quality bonds. Like an S&P 500 fund in equities, an Agg fund lets investors buy a large basket through a mutual fund or exchange-traded fund, rather than selecting individual securities.

Steve Laipply, global co-head of iShares Fixed Income ETFs, told CNBC that an Agg fund should be considered in relation to the investor’s objective, rather than treated automatically as a complete answer for fixed income exposure.

Why investors use the Agg

Bonds have historically offered lower long-term returns than equities, but they also tend to fluctuate less and respond to different forces. That makes them common in portfolios built with capital preservation, income or shorter time horizons in mind, including savings goals such as a home purchase, according to experts cited by CNBC.

Mark McCarron, chief investment officer at Wescott Financial Advisory Group, told CNBC that he views the Agg as a useful core bond holding for clients seeking to reduce portfolio volatility. The index includes U.S. Treasurys, investment-grade corporate bonds and securitized debt, giving investors exposure to issuers with relatively low default risk.

The diversification mechanism is straightforward. A fund tracking the Agg owns many bonds across several high-quality segments of the market. That reduces dependence on the credit outcome of a single issuer, while still leaving investors exposed to the broad level of interest rates and the composition of the benchmark.

The risks inside a broad bond benchmark

Credit risk in the Agg is comparatively limited because the index is concentrated in Treasurys and other investment-grade securities. The larger issue for some investors is what that mix means for income and rate sensitivity.

U.S. government-backed debt accounts for 46% of the index, CNBC reported. Nick Lloyd, vice president at Novare Capital Management, told CNBC that the Agg’s increasing Treasury exposure means investors hold a larger share of what is commonly viewed as the lowest-yielding fixed income instrument, the risk-free rate.

Investors seeking more income could look beyond the Agg to lower-rated debt or funds with greater corporate-bond exposure, Lloyd told CNBC. Those alternatives can carry higher credit risk, since issuers with lower ratings or corporate borrowers may be more vulnerable to missed payments than the U.S. government or top-rated borrowers.

Interest-rate risk is another feature of Agg exposure. CNBC reported that the index has a duration of 5.7 years. Duration measures a bond portfolio’s sensitivity to changes in rates: a fund with that duration would be expected to fall about 5.7% if rates rose by 1 percentage point, before accounting for other market factors.

That risk is in focus because traders were pricing an 87% probability that the Federal Reserve would raise interest rates by at least a quarter percentage point by year-end as of Tuesday, according to CME’s FedWatch tool, CNBC reported.

Experts cited by CNBC said investors should consult a financial professional before changing portfolios in response to rate expectations. Depending on objectives, an Agg fund may sit alongside other fixed income funds designed to reduce overall rate sensitivity, add inflation protection or diversify income sources.

Laipply told CNBC that fixed income allocation should be built around diversified sources of income and a clear understanding of the risks being taken.

This story draws on original reporting from CNBC.