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SEPTEMBER2017

EDWARDKERSCHNER, CFA
CHIEFPORTFOLIOSTRATEGIST BEYONDTHEBONDBENCHMARK
GENETANNUZZO, CFA
AMULTI-SECTORBONDSTRATEGYFILTERED
SENIORPORTFOLIOMANAGER, FOROPPORTUNITYRATHERTHANINDEBTEDNESS
FIXEDINCOMEINVESTMENTS

DAVIDJANSSEN, CFA
SENIORPORTFOLIOMANAGER, The growth of the U.S. bond market
FIXEDINCOMEINVESTMENTS
The United States, initially as the Continental Congress, rst incurred debt in 1776
NEERAJAGARWAL when it borrowed funds to nance the Revolutionary War.1 Total Treasury debt
INVESTMENTSTRATEGIST remained fairly small in the rst half of the 19th century but rose sharply with the
Civil War and again with World War I (Exhibit 1). After declining slightly, the debt
increased nearly threefold during the Great Depression and exploded in the 1940s
as the government nanced expenditures related to World War II.
Key findings
Allocating by debt From its postwar low in 1949, outstanding Treasury debt grew gradually for nearly
outstanding creates a two decades before accelerating at the time of the Vietnam War and during the
lopsided yield distribution, subsequent period of high ination. In the 1980s, the growth of the stock of debt
with a barbell-like picked up further, spurred by the tax cuts and rapid increases in defense spending
overconcentration both of the decade.2 Americas continuing and growing budget decits, combined with
in relatively safe-haven the unprecedented government intervention in U.S. nancial markets in 2008
assets with a limited including the mortgage-backed securities (MBS) issued by Fannie Mae and Freddie
income profile and in Mac, have driven the explosion in U.S. government debt outstanding.
fundamentally risky
debt profiles. Exhibit 1: U.S. government debt out st anding
17902017
The benchmark index does
not foster diversification, 100,000
with a two-thirds weighting 10,000
to government affiliated
Outstanding debt ($ billion, log scale)

1,000
bonds and high correlation
between the two largest 100
(1790 May 2017)

sectors. 10
Investors should consider 1
a multi-sector bond strategy 0
filtered for opportunity
0
rather than indebtedness.
Such a strategy could 0
address the investment 0
universe screened by yield, 0
1790

1805
1820

1835

1850

1865

1880

1895

1910

1925

1940

1955

1970

1985

2000

2015

quality and liquidity.

Source: U.S. Department of the Treasury. Data as of 08/ 31/ 17.

1
Rafael A. Bayley, The National Loans of the United States of America from July 4, 1776 to June 30, 1880, as Prepared for the Tenth Census of the United States (Washington, DC:
U.S. Government Printing Ofce, 1883).
2
The Treasury Securities Market: Overviewand Recent Developments http:// eh.net/ database/ u-s-government-bond-trading-database-1776-1835/.
BEYONDTHEBONDBENCHMARK
AMULTI-SECTORBONDSTRATEGYFILTEREDFOR
OPPORTUNITYRATHERTHANINDEBTEDNESS

The birth of a bond benchmark


On May 26, 1896, Charles Dow created what we now The Agg is more than an index. It is the basis for
know as the Dow Jones Industrial Average. But total return financial products that represent a majority of fixed-
bond indices werent developed until 1973. The growth income allocations for many investors. For example,
of asset allocation in portfolio management in the 1970s the iShares Core U.S. Aggregate Bond ETF, launched
necessitated a measure of bond performance. Hence the September 26, 2003, is the worlds largest bond ETF,4
need for a bond return benchmark. Until then, bonds were with assets of $45 billion. Thats equal to about 10%
rarely traded, and most investors just bought and held of the total assets invested in U.S.-listed domestic
them to maturity. fixed income ETFs 249 funds in all.

In 1973 Art Lipson and colleague John Roundtree at


Kuhn, Loeb & Co. created what later would be called the
Agg. Lehman Brothers purchased Kuhn, Loeb & Co. at
the end of 1977, and Barclays Capital took over the index Challenges with the bond benchmark:
business of the now-defunct Lehman Brothers in 2008.
Sector diversication
In 2016 Bloomberg acquired Barclays Risk Analytics and
Index Solutions Ltd., giving us what is currently called the The nancial crisis of 2008 and subsequent government
Bloomberg Barclays U.S. Aggregate Bond Index the Agg. intervention has changed the complexion of the U.S. bond
market. In 2007 the Agg was 22% U.S. Treasuries, but that
While manually calculating the value of a 30-stock index has increased to 37%today. Factoring in debt issued by
(the Dow Jones Industrial Average) was feasible, it was the government agencies 5 and mortgage-backed securities,
appearance of computers in the nancial industry in the the total government exposure is now over 70%(Exhibit 3).
1970s that enabled Mr. Lipson, an engineering major in Additionally, the Agg weightings historically exhibit high
college, to develop a program to keep track of more than correlations among the top components. (Exhibit 4). The
3,500 bonds. These bonds had a total value of $221 billion correlation of the top two components, U.S. Treasuries
at inception.3 Now, the Agg comprises a total of more than and MBS, is 81%with minimal exposure to those
9,300 bonds and is worth nearly $20 trillion (Exhibit 2). components with low-cross-correlations.

By default, bond market investors who use the Agg have


Exhibit 2: Bloomberg Barclays U.S. Aggregat e Bond their largest position in the lower left of the xed-income
Index market value
risk-reward prole (Exhibit 5): these types of bonds have
19762017
historically exhibited low return and low volatility.
20,000
U.S. Agg Index, market cap ($ billion)

18,000 Exhibit 3: Bloomberg Barclays U.S. Aggregat e Bond Index,


16,000 sect or breakdown (%)
14,000
Supranational 1.6 Sovereign 1.0 Local authorities 1.0
12,000 ABS0.5
10,000 Utility 1.7 Covered 0.1
8,000 CMBS1.8
6,000 Agencies 3.5
4,000
2,000 Financial institutions 8.0
0 Treasuries
76 80 84 88 92 96 00 04 08 12 16 37.1
Industrial
Source: Bloomberg, data as of 08/ 31/ 17.
15.6

MBS
pass-through
3
Barclays Agg Had Modest Origin, The Wall Street Journal, April 2, 2013. 28.1
4
The iShares ETFs are not sponsored, endorsed, issued, sold or promoted by
Columbia Threadneedle Investments.
5
Government agencies includes Agencies, Supranational and Local Authorities
as shown in Exhibit 3. Source: Bloomberg, data as of 08/ 31/ 17.

2
BEYONDTHEBONDBENCHMARK
AMULTI-SECTORBONDSTRATEGYFILTEREDFOR
OPPORTUNITYRATHERTHANINDEBTEDNESS

Exhibit 4: Agg component s, correlat ion


(01/ 31/ 0608/ 31/ 17)

MBSpass- Financial Supra- Local


Treasuries Industrial Agencies Utility CMBS Sovereign ABS Covered
through institutions national authorities
Treasuries 1.00
MBSpass-through 0.81 1.00
Industrial 0.51 0.63 1.00
Financial institutions 0.23 0.34 0.72 1.00
Agencies 0.93 0.87 0.64 0.39 1.00
Utility 0.57 0.66 0.95 0.66 0.65 1.00
Supranational 0.90 0.82 0.55 0.35 0.92 0.56 1.00
CMBS 0.02 0.06 0.49 0.44 0.18 0.37 0.13 1.00
Sovereign 0.57 0.66 0.83 0.62 0.71 0.75 0.63 0.46 1.00
Local authorities 0.84 0.73 0.66 0.39 0.78 0.74 0.79 0.17 0.64 1.00
ABS 0.05 0.28 0.54 0.45 0.13 0.59 0.14 0.35 0.34 0.25 1.00
Covered 0.66 0.61 0.45 0.39 0.66 0.48 0.82 0.12 0.53 0.67 0.19 1.00

Source: Bloomberg, correlation calculated is based on monthly returns, data as of 08/ 31/ 17. Correlation ranges from +1 to -1. Positive correlation indicates returns moving
in the same direction, negative correlation indicates returns moving in opposite directions, and a correlation of 0 would indicate no relationship between the movement of the
two returns. For indexdenitions, please refer to the back page.

Exhibit 5: Agg components, risk-reward prole


20062017 The top two components of the Agg
7 have an 81%correlation.
Local authorities Utility
6 Sovereign
Industrial
CMBS
5 MBS pass-through Financial institutions
Total Return (%)

4 Supranational Treasuries
Agencies Covered Opportunity: Targeting less correlated sectors
3
ABS
There is diversication potential if you examine other
2 sectors of the bond market. Moving out along that risk-
1 reward prole nds opportunities that are both less
correlated (Exhibit 6) and have historically offered relatively
0 higher returns (Exhibit 7). Sectors like U.S. Corporate
0 2 4 6 8 10
High Yield, Global Treasuries and the Emerging Market
Standard Deviation (%)
USD Aggregate historically have had much lower cross-
Source: Bloomberg, data as of 08/ 31/ 17. correlations and are not found in the Agg (see Exhibit 6).

Exhibit 6: Multi-sect or, correlat ion


(01/ 31/ 0608/ 31/ 17)

Global treasury EM USD Investment-grade U.S. corp


U.S. Treasury U.S. MBS
ex U.S. aggregate corporate high yield
U.S. Treasury 1.00
U.S. MBS 0.81 1.00
Global treasury ex U.S. 0.50 0.51 1.00
EM USDaggregate 0.17 0.43 0.47 1.00
Investment-grade corporate 0.44 0.56 0.53 0.78 1.00
U.S. corp high yield -0.26 0.02 0.26 0.79 0.62 1.00

Source: Bloomberg, correlation calculated is based on monthly returns, data as of 08/ 31/ 17. Throughout this paper, Emerging Market USDAggregate or Emerging Market
Debt represents Emerging Market (EM) Sovereign debt denominated in U.S. Dollars; Global Treasuries or Global Tsy ExU.S. represent non U.S. Treasuries. For indexdenitions,
please refer to the back page.

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BEYONDTHEBONDBENCHMARK
AMULTI-SECTORBONDSTRATEGYFILTEREDFOR
OPPORTUNITYRATHERTHANINDEBTEDNESS

Exhibit 7: Multi-sect or, risk/ ret urn prole Similarly, the developed market (DM) and emerging market
20062017 (EM) distinctions create anomalies. Highly indebted Italy
9 with a 133% debt/ gross domestic product (GDP) ratio
U.S. corp high yield
8 and Portugal (130%) are classied as developed markets
7 EM USDaggregate and Chile (21%) and South Korea (39%) are classied as
emerging markets.6
6
Total Return (%)

Investment-grade corporate
5 U.S. aggregate Lastly, post-crisis regulation has created a broad spectrum
U.S. MBS of liquidity. High-quality securities U.S. Treasuries, Agency
4
U.S. Treasury mortgage backed securities are generally more liquid and
3 Global treasury ex. U.S.
offer lower yields, while riskier, higher yielding securities may
2
trade less frequently, if at all. Trading in these less liquid
1 markets can create high volatility.
0
0 2 4 6 8 10 12
Standard Deviation (%) Opportunity: Cleaning up the bond benchmark
Source: Bloomberg, data as of 08/ 31/ 17. For index denitions, please refer to the We believe a multi-sector bond strategy ltered for opportunity
back page.
rather than indebtedness may provide a better balance of
yield, quality and liquidity than the benchmark. Such a strategy
Challenges with the bond benchmark: could address the investment universe screened by:
Yield, quality and liquidity Yield: Include multiple sectors throughout the U.S. and
In equity markets, investors typically rely on market- around the globe, including some that are not part of
capitalization-weighted benchmark indices. Arguably size the Agg.
can be associated with quality. However, many investors
Quality: Avoid the tails of the market by removing certain
have traditionally used products that track the debt-weighted
sectors (e.g., Japan, highest grade/ low-yield corporates)
Bloomberg Barclays U.S. Aggregate Bond Index as their core
that offer no risk premium and low-quality tiers (e.g.
xed-income allocation, and when it comes to xed income
Venezuela, lowest grade/ high-yield corporates) that could
the largest issuers do not follow the same logic. These
potentially have massive downside risk.
challenges are illustrated in a number of ways.
Liquidity: Focus on issues with sufcient tradability to
First, allocation by debt outstanding creates a lopsided yield provide investors with liquidity when they need it, with
distribution, with a barbell-like overconcentration between volatility that is tolerable.
relatively safe-haven assets (e.g., U.S. Treasury, Japan
Additionally, by incorporating the points above, investors
government bonds, highly rated/ large-cap corporates), with
seeking higher returns could be well-served to move out along
a limited income prole on one end and fundamentally risky
that risk/ return prole, appropriately reweighting components
debt proles (e.g., Italy, Venezuela, highly indebted/ low-rated
and, importantly, ltering those components to reduce market
corporates) on the other end.
factor idiosyncrasies, as seen on the next page.
Secondly, archaic segmentation creates distortion in
credit quality, which may present a challenge for investors
especially within the investment grade (IG) and high yield
(HY) markets. The IG market includes high-rated/ low-yielding
bonds, while the HY market includes issuers with bloated
capital structures and spotty liquidity. While the IG market
may have attractive characteristics for investors, there is a
large range of issuers in the market, with only about 10%
of bonds actually trading at the average yield. For example,
certain highly rated, liquid bonds issued by large companies
trade at essentially government bond yields.

6
International Monetary Fund (IMF), data as of April 2017.

4
Conclusion
Investors have traditionally used products that track the Bloomberg Barclays U.S. Aggregate Bond Index as their core
xed-income allocation. As we enter a new rate regime, investors may need to adjust their xed-income portfolios to avoid
overconcentration and minimize interest rate risk. Allocation by debt outstanding creates a lopsided yield distribution,
with a barbell-like overconcentration both in relatively safe-haven assets with a limited income prole and in fundamentally
risky debt proles. The bond benchmark does not foster diversication with historically high correlations among the largest
components. Additionally, archaic segmentation creates distortion in credit quality. Investors should consider a multi-
sector bond strategy ltered for opportunity rather than indebtedness. Such a strategy could address the investment
universe screened by yield, quality and liquidity. In the current lower rate environment investors seeking higher returns
could be well-served by appropriately reweighting components and, importantly, ltering those components to reduce
market factor idiosyncrasies.

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Bloomberg Barclays USAgg Industrial Total Return Value Unhedged USD(Industrial) ispart of the USCorporateIndex(credit) representing theindustrial sector. Bloomberg Barclays USAgg Finance
Total Return Value Unhedged USD(Financial institutions) is part of the USCorporate Index(credit) representing the nance sector. Bloomberg Barclays US Agg Utility Total Return Value Unhedged
USD(Utility) ispart of theUSCorporateIndex(credit) representingUtilitysector. BloombergBarclaysUSAgg SupranationalsTotal Return ValueUnhedged USD(Supranationals) ispart of theUSCredit
(non-corporate) Index. Supranational bonds are issued with the purpose of promoting economic development for the countries like International Bank for Reconstruction & Development, Inter-American
Development Bank, etc. Bloomberg Barclays US Agg CMBS Erisa Eligible Total Return Value Unhedged USD (CMBS) is an Index that measures the market of conduit and fusion CMBS deals with a
minimumcurrent deal sizeof $300mn. BloombergBarclaysUSAggSovereignTotal Return ValueUnhedgedUSD(Sovereign) includesbondsissuedbyforeigngovernments. BloombergBarclaysUSLocal
AuthorityTRTRIndexValueUnhedged USD(USLoc Auth) includes bonds issued by the local governments such as the State of Illinois, State of California, NewJerseyState Turnpike Authority. Bloomberg
Barclays USAgg ABSTotal Return Value Unhedged USD(ABS) includesasset backed-auto loans, home equityloans, and credit card debt. Bloomberg Barclays Covered Bonds USDTotal Return Index
Value Unhedged USD(Covered) includesbondsissued bybanks, institutionsand collateralized against a pool of assets. The BloombergBarclays USAggregate Bond Index(U.S. Aggregate) isa broad-
based benchmark that measures the investment grade, USdollar-denominated, xed-rate taxable bond market. The indexincludes Treasuries, government-related and corporate securities, MBS(agency
xed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). The Bloomberg Barclays US Treasury Index (U.S. Treasury) measures US dollar-denominated, xed-rate, nominal
debt issued bytheUSTreasury. Treasurybillsareexcluded bythematurityconstraint, but are part of aseparateShort TreasuryIndex. The BloombergBarclays USMortgageBacked Securities Index(U.S.
MBS) tracksagencymortgagebacked pass-throughsecurities(both xed-rateand hybrid ARM) guaranteed byGinnieMae(GNMA), FannieMae(FNMA), and Freddie Mac (FHLMC). The indexisconstructed
by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage. The Bloomberg Barclays Global Aggregate Index (Global Treasury) is a agship
measureof global investment gradedebt fromtwenty-four local currencymarkets. Thismulti-currencybenchmarkincludestreasury, government-related, corporateandsecuritizedxed-ratebondsfromboth
developed and emergingmarketsissuers. The BloombergBarclaysEmerging MarketsHard CurrencyAggregateIndex(EMUSDAggregate) isaagship hard currencyEmergingMarketsdebt benchmark
that includes USD-denominated debt fromsovereign, quasi-sovereign, and corporate EMissuers. The Bloomberg Barclays USCorporate Bond Index (U.S. Investment Grade Corporates) measures the
investment grade, xed-rate, taxablecorporate bond market. It includesUSDdenominated securities publiclyissued byUSand non-USindustrial, utilityand nancial issuers. The Bloomberg Barclays US
Corporate High Yield Bond Index(U.S. CorpHigh Yield) measurestheUSD-denominated, highyield, xed-ratecorporatebondmarket. Securitiesareclassiedashighyield if themiddleratingof Moodys,
Fitch and S&Pis Ba1/ BB+/ BB+ or below. Bondsfromissuers with an emergingmarketscountryof risk, based on Barclays EMcountrydenition, are excluded.
Indices shown are unmanaged and do not reect the impact of fees. It is not possible to invest directly in an index.
There are risks associated with xed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest
rates fall and vice versa. This effect is usually more pronounced for longer term securities. Securities issued or guaranteed by federal agencies and U.S. government-sponsored
instrumentalities may or may not be backed by the full faith and credit of the U.S. government, and the U.S. government maybe unable or unwillingto honor its nancial obligations.
Non-investment-grade (high-yield or junk) securities present greater price volatility and more risk to principal and income than higher rated securities. International investing
involves certain risks and volatility due to potential political, economic or currency instabilities and different nancial and accounting standards. These risks are enhanced for
emerging markets issuers. Diversication does not assure a prot or protect against loss.
The views expressed are as of September 2017, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment
Advisers, LLC(CMIA) associates or afliates. Actual investments or investment decisions made by CMIA and its afliates, whether for its own account or on behalf of clients, will
not necessarily reect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment
decisions should always be made based on an investors specic nancial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable
for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change
frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Investment products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment
Advisers, LLC.
Columbia Threadneedle Investments (Columbia Threadneedle) is theglobal brand nameof theColumbia and Threadneedlegroup of companies. Columbia Management Investment
Distributors, Inc., 225 Franklin Street, Boston, MA02110-2804
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