A Silver-Rated ETF for Core Bond Exposure
Broad diversification and low costs make this fund a good option for core fixed-income exposure.
Schwab U.S. Aggregate Bond ETF (SCHZ) is a great selection as a core investment-grade bond fund, in large part because of its rock-bottom fee. Its conservative portfolio further sets it up for long-term success. It earns a Morningstar Analyst Rating of Silver.
The strategy tracks the Bloomberg Barclays U.S. Aggregate Bond Index, which includes investment-grade U.S.-dollar-denominated bonds with at least one year until maturity. The index is weighted by market value, tilting the portfolio toward the largest, most liquid issues, which are easy to obtain and cheap to trade. This approach also harnesses the market's collective wisdom about the relative value of each security, which is a prudent approach for the long term. That said, bond-issuing activity influences the composition of this portfolio.
The government is the largest debt issuer in the United States, so the portfolio has a larger position in Treasuries than the intermediate core bond Morningstar Category average. The strategy invests nearly 65% of its assets in Treasuries and agency mortgaged-backed securities, which carry AAA ratings, while the corresponding figure for the category average is only about 45%. While this limits the fund's return potential, its lower credit risk should offer better downside protection.
This is a conservative portfolio with minimal credit risk. And while this can make it a low hurdle for active managers to beat, that does not detract from its appeal. Risk and return are highly correlated in the fixed-income market, so additional risk exposure is not necessarily ideal. Nearly 75% of the assets in this portfolio are rated AAA, making this one of the more conservative options in the category. After controlling for risk, this portfolio is tougher to beat. Like most investment-grade portfolios, interest-rate risk is the biggest driver of this fund's returns. Its average effective duration was about 5.5 years as of August 2020, in line with the category average.
While corporate bonds represent just about 25% of the portfolio, about half of those assets were in bonds rated BBB at the end of August 2020.
This portfolio replicates the composition of the U.S.-dollar-denominated investment-grade bond market, effectively harnessing the market's collective wisdom about the relative value of each bond. This is a sound approach because it promotes low turnover, limits credit risk, and is cost-effective, and also because the market does a decent job pricing these bonds. The strategy earns an Above Average Process rating.
The strategy employs representative sampling to track the performance of the Aggregate Index, which includes investment-grade U.S.-dollar-denominated bonds with at least one year until maturity. Qualifying bonds must have at least $300 million in outstanding face value. The index weights its holdings by their market value and is rebalanced monthly. This yields a conservative portfolio, which limits its return potential, but also cuts downside risk.
The composition of the portfolio is conservative, reflecting the size and quality of the U.S. investment-grade bond market. The amount of debt issued by the U.S. Treasury Department grew sharply since the global financial crisis, and the portfolio's exposure to Treasury bonds grew as a result. While this limits the fund's return potential, it also limits potential losses.
At the end of August 2020, Treasury bonds represented just under 40% of the fund's assets, while the corresponding figure for the category average was just under 20%. Agency MBS and corporate debt composed most of the balance. These sectors represented about 26% and 27% of the portfolio, respectively. Consequently, the fund's performance is driven primarily by interest-rate risk.
Although corporate bonds only represent about one fourth of the portfolio, these holdings are where most of the fund's credit risk resides. In addition to the growth of Treasury bonds, the U.S. corporate-bond market also grew in response to global financial crisis, as companies issued debt to capitalize on low interest rates. As a result, BBB corporate bonds now represent about half of the market value of all investment-grade corporate bonds. Accordingly, just under 15% of the portfolio is invested in bonds rated BBB.
The strategy's interest-rate risk is line with category peers. At the end of August 2020, its average effective duration was 5.5 years.
Schwab's passive fixed-income portfolio management team has consistently provided tight index-tracking. Its thoughtful process to portfolio construction and continued investment in technology have distinguished it from the pack. The team warrants a People Pillar rating upgrade to Above Average from Average.
Matt Hastings, Mark McKissick, Steven Hung, and Alfonso Portillo are each named portfolio managers for this strategy and have been since at least 2017. Hastings leads the bond index portfolio management team, and he has managed the fund since its inception in 2011. McKissick joined Schwab in 2016 and has been a named portfolio manager since 2017. He leads the government team, which consists of four other portfolio managers, including Portillo. Hung leads the credit team, which consists of three additional portfolio managers.
Schwab has a simpler fund lineup than some of its larger peers, so its fixed-income index management team is smaller. However, it makes efficient use of its resources and is well equipped to deliver cost-efficient and high-fidelity index-tracking for the strategies it manages.
Schwab aligns manager compensation with investors' interests. Managers are compensated based on the one- and three-year excess returns of their fund relative to the index (where the objective is to get that figure as close to zero as possible), as well as on their risk-management performance.
The fund's performance from its inception in July 2011 through August 2020 was solid. Although it trailed the category average by 8 basis points annually, it also provided better downside protection and was less correlated to the U.S. stock market. For example, during the novel coronavirus-driven sell-off between Feb. 19, 2020, and March 23, 2020, the fund lost 75 basis points, while the category average lost 3 percentage points. The fund's Treasury-heavy tilt was its greatest asset; it served as a refuge when credit risk and demand for liquidity spiked. During that time, corporate bonds fared poorly.
But similarly, the strategy is likely to lag when credit risk is rewarded. That was the case during 2012, when the ICE Bank of America BBB Option-Adjusted Spread contracted by about 1%, and the strategy lagged the category average by nearly 2%.
That does not diminish the case for this strategy, however, as many category peers court additional credit risk to derive higher returns. While that can be profitable, credit risk tends to be correlated to equity risk, which can hurt the potential diversification benefits of a core bond fund within a wider portfolio context.
Neal Kosciulek does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.