Fixed Income  

Bypassing heavily indebted issuers

This article is part of
Fixed Income Investing - January 2016

Bond investing has often been described as like picking up pennies in front of a steamroller. The biggest fear is that the steamroller gathers speed and we can’t get out of the way in time.

Illiquidity and ever-increasing debt burdens make this imagery all too real.

So why do traditional bond indices encourage investors to buy more bonds from the companies and countries that have already borrowed the most?

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If you were a bank manager and decided to lend more to a customer simply because they had already borrowed plenty, you would be dismissed.

However, this is the approach a conventional bond index takes. It is calculated based on the market cap of the outstanding bonds. Therefore, the bigger borrowers tend to have a larger weighting in the index – the higher the borrowing, the bigger the steamroller.

Government bond indices are concentrated on the most indebted countries, while stronger economies are underrepresented. It’s the same for corporate bond indices, where market-cap benchmarks are overexposed to highly leveraged sectors such as miners and energy firms.

However, investors need not despair. Alternatives indices have been created, from basic GDP-weighted solutions to a more comprehensive fundamental range that aims to better assess the reliability of a borrower. Such approaches can be accessed through funds and now exchange-traded fund formats.

Size matters, and the fundamental approach generally gives a higher weighting to larger countries, which are more capable of paying their debts. It gauges a country’s ability to service debt by looking at its debt burden, government budget and current account deficits and whether public finances are improving or worsening.

It also tracks social and political stability. Misery and political risks have led to major debt defaults, such as Russia in 1917 or Argentina in 2002. Old-age dependency can cause a surge in public debt as governments shoulder the burden of old-age care.

In the traditional global market-cap index, Japan is almost one third of the index due to its high proportion of bonds outstanding. Sure, Japan’s GDP makes it the world’s third-largest economy, but its public debt represents more than 200 per cent of GDP. Hence Japan has a lower weighting on a fundamental basis, in spite of its huge economy, and it is also penalised for its high old-age dependency ratio.

Corporates are just as bad at over-borrowing, which often occurs by sector, and typically all corporates will over-borrow at the same time. Investors often mistakenly believe a sector’s size in a corporate bond index resembles its weight in an economy – if only it were that simple.

Banks and insurers used to make up nearly half of the investment-grade corporate bond index. There was a 15 per cent fall in corporate bonds issued by financial companies in September 2008. Investors suffered losses from this because they were over exposed to financials.

In current markets, US high yield is struggling with an outsized weighting to energy and basic materials.