Bond index funds are not a one-size-fits-all market bet

Buying a broad index fund is often treated as the default move for stock investors, but bond investors face a more complicated choice. The main bond benchmark, the Bloomberg U.S. Aggregate Bond Index, can be useful, experts say, yet it may not match every investor’s need for income, stability or inflation protection.

The stock version of “buy the market” usually points to owning a low-cost fund tied to a broad index such as the S&P 500. ETF Database says the three largest exchange-traded funds by assets track the S&P 500, making it the most common shorthand for broad U.S. stock exposure.

In bonds, the closest equivalent is the Bloomberg U.S. Aggregate Bond Index, often called the Agg. It tracks a large basket of U.S. investment-grade debt, meaning bonds rated by credit agencies as having lower default risk. Investors can buy mutual funds or exchange-traded funds that follow the index.

What the Agg can do in a portfolio

Bonds are IOUs issued by governments or companies. They have historically offered lower long-term returns than stocks, but they tend to swing less in price and can behave differently when the stock market falls.

That makes them common in portfolios focused on preserving money rather than maximizing growth. Experts cited by CNBC said bonds may appeal to risk-conscious investors or people saving for nearer-term goals, such as a home purchase.

Mark McCarron, chief investment officer at Wescott Financial Advisory Group, said an Agg fund can work as a core bond holding for investors who want to reduce portfolio volatility. He pointed to its mix of Treasurys, investment-grade corporate bonds and securitized bonds, which are debt backed by pools of assets such as mortgages or loans.

That broad mix spreads exposure across many issuers and bond types. In plain English, the fund is not relying on one company or one kind of debt to do all the work.

The trade-offs investors should know

The Agg carries relatively low credit risk, which is the risk that a borrower fails to make promised payments. CNBC reported that Treasurys and other investment-grade bonds make up much of the index.

That lower credit risk comes with a yield trade-off. Nick Lloyd, vice president at Novare Capital Management, noted that Treasurys now account for 46% of the index. Because U.S. government debt is treated as very low risk, it typically pays less than riskier bonds.

Lloyd said the Agg’s growing Treasury weight means investors have been holding more of what he called the “lowest yielding fixed income instrument.” He added that Treasury yields are considered the risk-free rate.

Investors seeking more income could look at broader bond exposure that includes lower-rated debt or funds with more corporate bonds, Lloyd said. Lower-rated bonds generally pay more because investors are taking on more default risk.

Rate sensitivity is another issue. Lloyd said the Agg has a duration of 5.7 years. Duration measures how much a bond fund’s price may move when interest rates change. A fund tracking the Agg would be expected to fall about 5.7% if rates rose by 1 percentage point, based on that duration figure.

That risk is getting attention as markets price in tighter Federal Reserve policy. As of Tuesday, CME’s FedWatch tool showed traders saw an 87% chance that the Fed would raise interest rates by at least a quarter point by year-end, CNBC reported.

Steve Laipply, global co-head of iShares Fixed Income ETFs, said adding an Agg fund should depend on what an investor is trying to accomplish. He said bond portfolios should be diversified by income source, with attention to the risks attached to each piece.

Experts cited by CNBC also said investors should speak with a financial professional before changing a portfolio based on expected interest-rate moves.

This story draws on original reporting from CNBC.