AGG vs. IEI: A Quantitative Analysis for Portfolio Construction in a Volatile Rate Environment

For a disciplined portfolio manager, the decision between these two ETFs is a fundamental allocation call. It pits a pure-duration Treasury hedge against a diversified, higher-yielding core holding. The choice is not about which is "better," but which best serves the portfolio's specific need for credit risk, duration exposure, and income generation.

The iShares 3-7 Year Treasury Bond ETF (IEI) is the quintessential pure-duration instrument. It offers a focused, low-cost vehicle to gain exposure to intermediate-term U.S. Treasuries, the market's highest-quality benchmark. Its expense ratio of 0.15% is low, but its primary value is in its minimal credit risk and high sensitivity to interest rate changes. The fund's effective duration is approximately 5 years, making it a direct lever on the Treasury yield curve. This makes IEI a powerful tactical tool for hedging interest rate risk or taking a directional view on the path of intermediate yields. However, its performance is directly tied to Treasury movements, offering no diversification benefit from other sectors of the bond market.

In contrast, the iShares Core US Aggregate Bond ETF (AGG) is a diversified core holding. It captures the entire U.S. investment-grade bond market, including corporate bonds and mortgage-backed securities. This broad mandate provides significant diversification, but it comes with added risks. AGG carries both credit risk and prepayment risk, which are absent from IEI's pure Treasury portfolio. Its expense ratio of 0.03% is notably lower, and it offers a higher current yield of 3.9% versus IEI's 3.5%. This income premium is the reward for accepting that broader risk profile. Historically, AGG has also experienced a deeper drawdown, with a maximum drawdown of -17.83% over five years compared to IEI's -14.05%.

The strategic role is clear. IEI is a portfolio's pure-duration hedge. It is the tool for reducing interest rate sensitivity or for a tactical bet on Treasury yields. AGG, on the other hand, is a core income generator. It provides a diversified, liquid, and relatively low-cost way to capture the yield of the broader investment-grade market. For a portfolio seeking to manage volatility and generate stable income, AGG's diversification is a key feature. For a portfolio needing a precise, low-risk Treasury hedge, IEI's purity is its strength.

The choice, therefore, is a function of the portfolio's current risk budget and objectives. If the primary goal is to hedge against a rate shock or to hold a high-quality, low-duration anchor, IEI is the instrument. If the goal is to build a diversified, income-producing core that can weather credit spreads and provide a buffer against equity drawdowns, AGG is the logical choice. In a volatile rate environment, a manager might even hold both-a core of AGG for income and a tactical overlay of IEI for duration control.

Portfolio Construction Implications: Correlation and Risk-Adjusted Return

For a portfolio manager, the choice between IEI and AGG is ultimately a decision about risk budgeting and diversification. In today's environment of elevated volatility and a Fed policy that has distorted historical yield curve behavior, their correlation dynamics and risk-adjusted returns are critical. The key insight is that while both can act as diversifiers, they do so in fundamentally different ways and carry distinct risk profiles.

The primary risk for IEI is interest rate volatility. As a pure-duration Treasury instrument, its performance is directly tied to the path of intermediate yields. Evidence shows that since the first rate cut in September 2024, intermediate and longer-term interest rates have increased by around 65 bps. This "higher-for-longer" dynamic heightens the duration risk of IEI, making it more vulnerable to sharp price declines if yields rise further. Its value as a diversifier is limited to its ability to hedge against Treasury-specific rate moves, but it offers no protection against credit spread widening-a risk that is entirely absent from its portfolio.

AGG, by contrast, provides a broader diversification benefit. Its portfolio of over 13,000 securities includes corporate bonds and mortgage-backed securities, which means its performance is influenced by both interest rates and credit spreads. This dual exposure introduces more complexity, but it can also provide resilience. In a scenario where credit spreads widen, AGG's corporate bond holdings would likely underperform, but its Treasury component would still offer some stability. This makes AGG a more robust "diversifier" for a portfolio, as it can help offset equity drawdowns through its non-Treasury holdings, even if its overall volatility is higher.

From a risk-adjusted return perspective, the trade-off is clear. AGG offers a higher current yield of 3.9% versus IEI's 3.5%, and its lower expense ratio of 0.03% enhances net returns. However, this comes with a deeper historical drawdown of -17.83% compared to IEI's -14.05%. In a volatile rate environment where the term premium has returned, this added credit and prepayment risk must be weighed against the income premium. The portfolio manager must ask whether the higher yield justifies the additional volatility and the potential for larger losses if both rates and spreads move against the position.

The bottom line for portfolio construction is that these ETFs serve different strategic roles. IEI is a tactical tool for pure-duration exposure or a hedge, but its risk profile is straightforward and sensitive to the specific segment of the yield curve it targets. AGG is a core holding designed to generate income and provide diversification across the investment-grade universe. Its risk-adjusted return depends on the manager's ability to navigate the interplay between interest rate changes and credit market conditions. In a portfolio, holding both could be a systematic strategy: using IEI to fine-tune duration risk while AGG provides the diversified income stream and broader market exposure needed to manage overall volatility.

Catalysts and Risks: What to Watch for Portfolio Rebalancing

For a portfolio manager, the static analysis of IEI and AGG is just the starting point. The real work is monitoring forward-looking catalysts that could shift their relative value and signal a need for tactical adjustment. The key is to watch the interplay of yield curve dynamics, credit spreads, and the broader volatility regime, as these factors will dictate which ETF serves as the better diversifier or income generator in the coming months.

The shape of the Treasury yield curve is a primary signal. A steepening curve, where long-term yields rise faster than short-term ones, typically favors longer-duration assets. This would benefit AGG, whose portfolio includes a significant weight in longer-maturity corporate and mortgage-backed securities. Conversely, an inversion-where short-term yields surpass long-term ones-has historically been a precursor to economic weakness and often increases demand for short- and intermediate-term Treasuries as a safe haven. In that scenario, IEI's focused exposure to the 3-7 year sector could become more defensive, as investors rotate out of longer-duration holdings. The current environment shows the Treasury yield curve remains inverted, with short-term yields near 4.3% and long-term bonds offering similar yields, a condition that has persisted since late 2024.

Credit spreads are the second critical variable. AGG's diversified portfolio means its performance is directly tied to the health of the investment-grade credit market. If spreads widen due to economic stress or sector-specific concerns, AGG will likely underperform IEI, which carries no credit risk. This widening would hurt AGG's total return and increase its volatility, potentially making IEI a more attractive defensive holding during periods of credit stress. The manager must watch for signs of spread deterioration, which would signal a shift in the risk-reward calculus for the diversified core.

The most profound risk, however, is the potential for unstable stock-bond correlation. Structural shifts in the economy have upended traditional diversification benefits. Since the pandemic, we have seen spikes in volatility and unstable stock-bond correlation, with the relationship turning positive in 2022 and dragging down traditional 60/40 portfolios. In such an environment, the portfolio's need for a true diversifier becomes paramount. While both IEI and AGG can act as hedges, their effectiveness depends on the correlation regime. If stocks and bonds move together in a downturn, the diversification benefit of holding either ETF diminishes. This makes a strategic approach to portfolio construction essential, potentially requiring a focus on other assets like real assets or targeted alternative strategies to provide true uncorrelated return streams.

The bottom line is that rebalancing is not a calendar event but a response to these catalysts. A manager should monitor the yield curve for signs of steepening or inversion, track credit spreads for widening pressure, and remain acutely aware of the volatility and correlation regime. These factors will determine whether the pure-duration hedge of IEI or the diversified income engine of AGG offers the better risk-adjusted return in the current volatile environment.