Dramatic policy interventions have produced massive distortions in the fixed income markets, reflected in overvaluations of most sectors in the Barclays Agg. Risk in fixed-income proceeds from four areas: term structure,
prepayments, credit, and liquidity. The Agg is currently biased toward term-structure risk. Active managers may be well positioned to target risks and opportunities outside the Agg.
PUTNAM INVESTMENTS | putnam.com
For several decades, the Barclays U.S. Aggregate Bond Index (known as the
Lehman U.S. Aggregate Bond Index until November 2008) has been a central
reference point for bond investors — a benchmark with widespread acceptance
comparable to the S&P 500 or the Dow Jones Industrial Average in the equity
world. The “Agg” comprises more than $17 trillion worth of bonds, based on
current market value, and was designed to include the whole landscape of
domestic, investment-grade fixed-income sectors, from U.S. Treasuries and
agency issues to mortgage-backed and asset-backed securities.
The Agg is the benchmark for multi-billion dollar institutional funds as well
as scores of mutual funds that seek to gain exposure to the broad spectrum
of the U.S. fixed-income universe. Many funds are designed to substantially
track the performance of the Agg, with the manager seeking to add alpha —
or outperformance of the index by virtue of skill — by overweighting or
underweighting its sectors. Some passive index funds seek to replicate its
performance as precisely as possible. Between passive exchange-traded funds
and index funds, actively managed mutual funds and institutional mandates,
many trillions of dollars are invested in strategies pegged to this benchmark, and
too often, this fact alone results in a significant misallocation of risk for investors.
In this paper, we explore how the Agg has come to represent a diminished
set of risks for fixed-income investors — and, hence, a diminished set of
opportunities. While the Agg is, of course, likely to remain a key touchstone
in the bond market, we believe that the financial crisis of 2008 and its still-
unfolding aftermath underscore why an approach to fixed-income investing
that targets risks and opportunities outside the index can be of particular
value to investors.
Bonds or bond funds?
Why a bond fund might be the better choice
for most clients
April 2013 » White paper
Thinking outside the index
D. William Kohli, Michael V. Salm, and Paul D. Scanlon, CFA
Co-Heads of Fixed Income
• Dramatic policy
distortions in the fixed-
income markets, reflected
in overvaluations of most
sectors in the Barclays Agg
• Risk in fixed-income
proceeds from four
areas: term structure,
and liquidity. The Agg is
currently biased toward
• Active managers may be
well positioned to target
risks and opportunities
outside the Agg
• Putnam’s team-based
approach offers the
depth of resources to
APRIL 2013 | Thinking outside the index
How the U.S. government came to support the
largest sectors in the index
The Barclays Agg was designed to reflect the broad U.S.
bond market. It is a purely “passive” index; as long as a
domestically issued bond meets criteria primarily based
on issue size, maturity, and credit rating, it is incorporated
into the index, and weighted according to its market
capitalization. By extension, if an investor believes that
the market as a whole is fairly valued, then a portfolio
that mirrors the index may be a perfectly suitable invest-
ment. However, our judgment today is that the U.S.
market, as represented by the Barclays Agg, does not
compensate investors for the risks it entails. We have just
come through a period of government intervention in the
bond market that was historic in size and scope. The U.S.
Federal Reserve responded to an economic emergency
with massive purchases aimed at adding liquidity and
stabilizing the market. As the dust has settled, we now
have an unprecedented fixed-income landscape:
•Between November 2008 and March 2010, the Fed
purchased $1.25 trillion of agency mortgage-backed
securities (MBS), representing about 25% of the
•Between October 2010 and June 2011, the Fed
implemented a second round of quantitative easing,
purchasing $600 billion in U.S. Treasuries, adding to the
approximately $300 billion already on the government’s
•Between October 2011 and December 2012, the Fed’s
“Operation Twist” used proceeds from maturing
holdings and the sales of short-term debt to purchase
intermediate- and long-term Treasuries in an effort to
drive down longer-term rates.
•In September 2012, the Fed announced a third round of
“QE,” this time targeting the mortgage-backed securities
market, with monthly purchases of up to $40 billion.
•In December 2012, the Fed replaced its expiring
Operation Twist program with an additional round of
easing authorized to purchase up to $45 billion a month in
longer-term Treasury debt.
•The federal funds rate currently hovers around zero,
and Fed Chairman Ben Bernanke has indicated that the
Fed would hold the rate down until there is substantial
improvement in the labor market, with unemployment
declining to 6.5%.
From a public policy perspective, it is hard to argue
that the Fed could have taken any other path in the wake
of the financial crisis and through the economic uncer-
tainty that has intermittently threatened to disrupt the
global recovery. However, any such dramatic, one-sided
market activity produces massive distortion, and we see
that today in the relative overvaluations of Agg sectors
that were targets of Fed purchases. Yields on govern-
ment securities, agency debt, and agency MBS are at
historically low levels, and spreads as of March 2013 have
tightened to levels at or below their 10-year pre-crisis
Because the prices of these securities have been
propped up by massive artificial demand, they offer
little upside potential, in our view, but great downside
potential as the Fed’s easy money policy is recalibrated
in light of evolving expectations for economic growth
and inflationary pressures. And as the era of easy money
enters what may be its final phase, the potential for rising
interest rates across developed markets is substantial.
Rethinking fixed-income risk
The traditional view of portfolio risk revolves around its
divergence from a benchmark. For many fixed-income
investors, therefore, risk has come to be understood as
a portÂ�folio’s deviation from the Agg itself. On this view,
the portfolio manager’s benchmark-relative decisions
about which sectors or industries to overweight and
underweight, and which securities to own or avoid, drive
all meaningful metrics of risk and return, from standard
deviation and alpha to information ratio. Because the
bond markets, as proxied by the Barclays Aggregate
indices, are generally thought to be efficient, conven-
tional wisdom has it that outperforming the benchmark
can only be achieved by assuming a greater degree of
risk — risk reflected by a portfolio’s deviation from the
allocations of the benchmark.
This belief is flawed, however, because it oversimplifies
the concept of risk. By conceiving risk as benchmark
deviation, it ignores how individual securities, whether
they are in or out of the benchmark, can represent
different forms and intensities of risk. At Putnam, we find
that fixed-income risks proceed from four areas: term
structure, prepayments, credit, and liquidity (See sidebar
on page 5).
PUTNAM INVESTMENTS | putnam.com
Through this view of the major risk categories, we
endeavor to quantify each of these risks at the secu-
rity level and use that analysis as the basis for portfolio
construction. When we filter the Agg through this
understanding of risk, moreover, we find that the index is
currently heavily tilted toward term-structure risk while
the other three risk categories are less well represented
or entirely absent.
The upshot of this concept is that potential returns
associated with the different sources of risk fluctuate
over time and according to the characteristics of any
given security. In other words, not all risks are — or should
be — considered equal, and they are rarely static in terms
of their potential negative or positive portfolio impact.
Critically, the result for any investment strategy that uses
the Agg as its starting point, we believe, is a signifiÂ�cant
over-allocation to the sources of risk that offer the least
potential for returns in today’s market.
There are a number of areas we believe offer the potential
for diversifying away from term-structure risk and also
offer the opportunity for further spread tightening rela-
tive to U.S. Treasuries (Figure 1). ImporÂ�tantly, these sectors
all share a common characteristic: They represent tiny
fractions of the Agg, and offer significant opportunities to
active fixed-income managers ( Figure 2).
At present, we see more value — and more worthwhile
forms of risk — in the $4 trillion worth of securities that
lie outside the Agg, along with some sectors in the Agg
that have not been targets of government intervention.
The key here is that the sources of risk inherent in these
sectors are far more diverse and much less contingent on
declining interest rates to fuel returns.
U.S. non-agency residential mortgage-backed
securities (RMBS) represent a prime example of one of
the opportunities available to active managers willing to
look beyond the benchmark. As securities that lack any
government support, U.S. non-agency RMBS returns are
driven primarily by credit risks, making them sigÂ�nificantly
less sensitive to changing interest rates than the vast
majority of the securities in the Agg.
In the wake of the financial crisis, prices of U.S. non-
agency RMBS were “marked down” severely, often
exceeding the declines in the value of the underÂ�lying
collateral. As is frequently the case, the market had
swung from extreme overvaluation initially to the under-
valued condition in the aftermath of the crisis. Despite a
strong rally in the sector and the fact that top-tier MBS
are first to be paid, many continue to trade at 70 or 80
cents on the dollar. While those securiÂ�ties may never
return to par value, we believe there remains an oppor-
tunity for capital appreciation, even if housing prices
decline and default rates increase.
Figure 1. Spreads appear attractive in certain sectors outside the Agg
Agencies 34 30 -4
Agency MBS 56 60 +4
Investment-grade corporates 130 139 +9
High yield 511 457 -54
AAA CMBS 89 115 +26
Non-agency RMBS 123 200–450 +77–327
Agency IO 150 350–700 +200–550
EMD 425 287 -138
Sources: Barclays, Putnam. Data as of 3/31/13.
* Option-adjusted spreads.
APRIL 2013 | Thinking outside the index
If we step back and look at the broader universe of MBS
outside of the Agg, we also find value in areas of the
interest-only agency collateralized mortgage obligations
(CMO IOs) market. Like an agency MBS pass-through,
many CMOs have the backing of a federal agency —
either Fannie Mae, Freddie Mac, or Ginnie Mae. CMOs are
created from a portion of the cash flow of an agency MBS
pass-through. Two of the most common CMO structures
are interest-only (IO) and principal-only (PO). As their
names suggest, CMO IOs receive the interest payments
on an underlying pass-through, while the CMO POs
receive principal payments. The value of an IO or a PO is
influenced by mortgage payments and prepayments.
CMO IOs can be attractive for two reasons. First, they
currently offer yields at relatively attractive spreads
over Treasuries. But they also offer the chance to add
alpha by understanding the dynamics of prepayments.
When a CMO IO is first sold, its price is calculated using
an assumed rate of prepayments, based on model esti-
mates. If prepayments proceed more slowly than the
assumed rate, then the CMO IOs become more valuable,
because the interest payments will be based on higher
principal amounts than originally assumed and will be
more numerous. (The slower prepayments would corre-
spondingly lower the value of the CMO POs.)
Prepayment rates can vary for a number of reasons.
The most common factor is interest rates: as they fall,
more homeowners typically are induced to refinance.
However, today, even with interest rates low, many
homeowners cannot refinance because the value of their
homes has declined and bank lending standards remain
tight. While we believe this will continue to be the case
heading into 2013, an improving housing market and a
healthier banking system will likely lead to an expansion
of credit over the next 12 months, and for those reasons
we have become more tactical in the CMO IO space.
We prefer to focus on lower coupon IOs, which may
benefit from higher interest rates, as well as IOs that
may be less affected by recent government programs
designed to spur refinancing activity.
Figure 2. Opportunities beyond the Agg
Barclays U.S. Aggregate Bond Index
$17 trillion market value
Average yield: 1.86%
$4.6 trillion market value
Average yield: 5.11%
Global high yield
Sources: Barclays, Putnam, as of 3/31/13.
PUTNAM INVESTMENTS | putnam.com
The result for any investment
strategy that uses the Agg as
its starting point, we believe,
is a signifiÂ�cant over-allocation
to the sources of risk that offer
the least potential for returns
in today’s market.
Pockets of value in term-structure risk
Although we contend that the Agg represents a poor
allocation of risks given today’s historically low interest
rates and the massive government intervention in the
bond markets, that is not to say that all term-structure
risk is undesirable. But the key to unlocking the more
worthwhile forms of term-structure risk, we believe,
is active management. For example, there are ample
opportunities for active managers to use discrepancies
in interest rates and global growth rates to their advan-
tage. Over the past five years, economic growth in select
emerging markets — including India, Taiwan, and South
Korea — has significantly eclipsed that of bellwether
developed markets including Japan, France, and the
This divergent global economic growth is exploitable
by managers who engage in the carry trade — i.e., who
pay low rates on borrowed funds that they invest in
longer-term securities with higher yields — or who
establish cross-border relative-value positions. But again,
these opportunity sets exist only outside the narrow
context of the Agg, which has almost no exposure to
below-investment-grade or emerging-market securities.
Putnam’s team-based approach to
Putnam favors an approach to fixed-income
investing that targets opportunities across the bond
markets, both inside and outside broad indices like
the Agg, while allocating assets toward those risks
most likely to offer attractive returns. In today’s
investment environment, with interest rates kept
artificially low in a number of develÂ�oped markets,
we believe the potential returns associated with
most term-structure risk within the constraints of
the government-heavy Agg are not commensurate
with their downside risks and opportunity costs.
Four types of fixed-income risk
Exemplified by bank loans, corporate bonds, and
emerging-market debt, as well as non-agency RMBS.
To analyze credit risk, one must focus intensely on
the issuers and their ability to meet their obligations
under a wide variety of economic conditions, as
well as the relative attractiveness of the yield on the
2. Term structure
Refers to the yield curves that exist in different
markets around the world, and typically involves the
relationship between short- and long-term rates,
monetary policy, and currencies. Anticipating the
changing shape of yield curves or the relative value
of currencies can be an important source of alpha.
Reflect the ability of a bond issuer or homeowner
to pay off principal before the stated maturity
date, typically done in a falling-rate environment.
When principal is prepaid, bond owners have to
find new investments — often with lower interest
rates. Understanding prepayment dynamics is an
important facet of active fixed-income investing,
particularly with respect to different types of CMOs.
Refers to the risk associated with the ability to trade
a security in a reasonable amount of time. This risk
can stem from either the security type (e.g., U.S.
Treasury notes are highly liquid versus emerging-
market bonds issued in local currencies) or market
APRIL 2013 | Thinking outside the index
Figure 3. Putnam’s integrated fixed-income investment process
Analysts uncover attractive opportunities in their markets
Sector teams promote strategies and allocate risk within subsectors
Portfolio construction team allocates risk based on return expectations
Portfolio managers direct trades within their risk budget
PUTNAM INVESTMENTS | putnam.com
The 2007–2008 credit crisis, in particular, demon-
strated the important role of professional research
independent of ratings agencies as the bond market
has become ever more varied, complex, and global. The
ultimate source of an investor’s interest and principal
may be a homeowner, a pool of credit card receivables,
a mortgage on commercial property, a corporate
borrower, a bank loan, or an emerging-market country.
The 2008–2009 environment underscored how
badly things can go when those factors are ignored or
The good news is that the variety and complexity of
global markets also provide a broad range of opportu-
nities for those with the skills and resources to discern
them. It requires a multidimensional approach that
goes beyond the traditional notion of “diversification by
sector” that is embodied in the Agg. That is why Putnam
has more than 70 fixed-income professionals focusing
on key areas such as global rates, securitized vehicles,
credit, emerging markets, currency, and portfolio
construction. We do not believe there are any shortcuts
that work in today’s fixed-income world, especially for
investments outside of the index. A broad approach
is needed with the flexibility to exploit all sectors and
opportunities, and with a grasp of the complex global
interrelationships that drive the market.
Under the leadership of a professional investment
group that has been working together for more than 10
years, Putnam has developed comprehensive coverage
of every aspect of the fixed-income world. The circle
in Figure 3 captures sectors as well as the four broad
sources of risk that we believe are most likely to drive
The inner core of portfolio construction knits
together Putnam’s fixed-income investment process in
a fashion that balances risk factors and maximizes the
opportunity for consistent income and positive return.
This is as much art as science, reflecting the portfolio
managers’ deep experience and understanding of
which sectors may be worth overweighting or under-
weighting over a particular period.
Putnam funds are positioned outside
Putnam funds pursue diversification across sectors
outside the index, while balancing credit, term structure,
prepayment, and liquidity risk.
For example, Putnam Diversified Income Trust in
March 2013 had broad weightings in high-yield
corporates, non-agency RMBS, and CMBS, along with
smaller exposures to emerging markets, investment-
grade corporates, and bank loans. All of Putnam’s
fixed-income funds share the advantage of being
relatively nimble, which is key to capitalizing on
out-of-index issues. Sectors outside the index tend
to be small, making it difficult to establish meaningful
portfolio weightings unless a fund has a relatively
modest level of assets under management.
Fixed-income markets today continue to ride out
historic changes relative to central bank policy, global
economic recovery, and financial market transforma-
tion. The emergency market intervention by the U.S.
government has resulted, in our view, in significant
overvaluation of the Barclays Agg and a concentration
of term-structure risk that reinforces the desirability
of diversifying the sources of risk in a portfolio. Out-
of-index sectors have not undergone the same buying
pressure, and, in our analysis, continue to present
value-add opportunities. Further, even as bond markets
evolve from the current post-crisis condition, we are
convinced that out-of-index investing will become
increasingly important to investors seeking the
traditional goals of steady income while minimizing risk
APRIL 2013 | Thinking outside the index
Putnam Retail Management | One Post Office Square | Boston, MA 02109 | putnam.com II891 280912 4/13
Fund returns and benchmark returns reflect security valuations and currency translations as of March 28, 2013.
Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio.
Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities. Barclays
Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities.
You cannot invest directly in an index.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations,
economic instability, and political developments. Additional risks may be associated with emerging-market securities,
including illiquidity and volatility. Lower-rated bonds may offer higher yields in return for more risk.
Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment
risk. The use of derivatives involves additional risks, such as the potential inability to terminate or sell derivatives positions
and the potential failure of the other party to the instrument to meet its obligations.
Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to
fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may
default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk
is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that
invest in bonds have ongoing fees and expenses. You can lose money by investing in a fund.
Request a prospectus, or a summary prospectus if available, from your financial representative or by
calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and
other information that you should read and consider carefully before investing.