BOND: Peak Rates Suggest Positive Performance (NYSE:BOND)

Thesis

The PIMCO Active Bond Exchange-Traded Fund (NYSE:BOND) is a fixed income ETF. The vehicle falls in the actively managed funds category, and is part of the behemoth Pimco family. The fund targets intermediate bonds and benchmarks itself against the Bloomberg U.S. Aggregate Index:

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. It is not possible to invest directly in an unmanaged index.

The best known ETF tracking the Bloomberg U.S. Aggregate Index is the iShares Core U.S. Aggregate Bond ETF (AGG). The important question to ask then for a retail investor is whether BOND is better than AGG and what the risk metrics utilized are. Pimco is fairly clear that BOND can have a different composition when compared to AGG, and in fact it does:

BOND takes more credit risk when compared to the Index as reflected by AGG. BOND does end up taking ‘good’ risk, as observed from its higher Sharpe ratio, and indeed does slightly outperform AGG longer term:

From a total return standpoint BOND pencils in a 4.4% performance versus 4.25% for AGG on a 5-year look back. The difference though is minute. BOND ends up outperforming via a higher corporate credit allocation, albeit with an improved Sharpe ratio. From a duration standpoint they are currently very close, so as it stands one can isolate the outperformance from the incremental credit risk.

Furthermore, we are comparing the fund here with the iShares 7-10 Year Treasury Bond ETF (IEF) and with the iShares iBoxx Investment Grade Corporate Bond ETF (LQD). As per the table above, the two mentioned funds have different compositions (one is 100% treasuries while the other is 100% investment grade corporate bonds) but they have individually segregated risk factors. What does that mean? It means that an investor buying IEF knows that it is taking only rates risk for the respective duration point in the yield curve, while an investment in LQD is a pure corporate risk factor (duration plus IG credit spreads). BOND is a bit of a mix, and a take on AGG.

We called BOND’s performance ‘muddled’ because it is not a clear outperformer when compared to AGG. We would have expected more from an active fund. In fact a simple portfolio composition using 50% IEF and 50% LQD would have produced a better performance on the same time frame (albeit with slightly higher duration).

Our view on rates is that we have seen a peak already, hence better times lay ahead for both AGG and BOND.

Holdings

The fund contains a mix of investment grade bonds:

Please note that the bucket identified as “Securitized” above is mainly composed of Agency mortgages:

The fund is mainly driven by rates and its duration point on the yield curve. With rates having peaked in our view, the fund is set to post positive performances going forward as the Fed is set to lower rates in 2024.

What does the future look like for BOND?

As discussed in the ‘Thesis’ and ‘Holdings’ sections, BOND is an active exchange traded fund that holds investment grade bonds. The ETF holds mostly Treasuries and Agency MBS securities, hence its performance will be mainly driven by rates. Treasury and Agency MBS bonds are AAA assets that price off the respective risk-free rate curve, rather than any implied credit risk curve. We are of the belief that we are seeking peak rates as we speak, after a violent rate hike cycle:

The forward curve is pricing lower rates in 2024 and onwards, which translates into BOND benefiting via its collateral. Given its duration (6 years) and carry profiles, we are expecting an 8% positive performance for the fund in the next 12 months.

Risk Factors

BOND is a fixed income vehicle mostly composed of AAA assets. Rates are the primary risk factor here, followed by credit spreads. The assigned Buy rating centers on the current forward curve, which is pricing much lower rates next year:

The main risk factor for a negative performance in BOND is a sudden spike in inflation, which would force the Fed to hike even further. We see a low probability of this occurrence happening.

Conclusion

BOND is an exchange traded fund. The vehicle holds mainly investment grade bonds, and aims to track to a certain degree the Bloomberg U.S. Aggregate Index. The fund has an active management approach, and is fairly clear in its literature that its portfolio will differ from the one exhibited by AGG, the ETF closely tracking the Bloomberg U.S. Aggregate Index. BOND does slightly outperform longer term, but it does so with an incremental credit risk factor (i.e., the vehicle just takes more credit risk via corporate bonds when compared to AGG). Its analytics look good, with a higher Sharpe ratio than AGG (meaning it takes ‘good’ risk) but its outperformance is extremely small (0.15% higher total return on a 5-year basis). The fund is set for a positive performance going into 2024 given we believe rates have peaked. The fund is set to benefit from lower rates, similarly to AGG, hence we are putting a Buy rating here and an 8% positive performance expected for the next 12 months.