Investors should look for risk to be compensated by attractive premia. But Christoph Gort argues that market-cap weighted bond indices fail to deliver this. New index methodologies will allow for more efficient global bond investing
Market capitalisation is still the dominant rule for the construction of most financial market indices. For fixed income investments, this means allocating the highest weights to issuers with the highest amounts of outstanding debt.
All other things being equal, we would probably all agree that challenging fundamentals such as high debt-to-GDP ratios or inflation fears increases the risks of bonds. Based on this economic intuition, we would expect bonds of highly-indebted issuers to get low weights in bond indices - but for most popular indices the opposite is the case today.
The basic idea of the market-cap approach is to weight constituents of an index according to their current market valuation. Applied to stocks, this makes sense under specific circumstances and strict assumptions.
Equity allows investors to benefit from a company's future profits and cashflows. If the market correctly discounts all expected future cashflows of stocks, market cap allocations efficiently mirror the equity investment universe, because stocks with larger expected future cashflows get higher index weights.
In contrast, for fixed income indices, the market-cap approach refers to outstanding debt amounts and thus assigns the highest index weights to the most heavily indebted issuers.
Bond investors do not benefit from any upside but bear the risk of not earning their interest and notional value according to the defined nominal terms - or, more importantly, in real terms. So why should an investor allocate most of their money to issuers with the highest outstanding debt amounts, which might affect the ability of the issuer to repay?
As obvious as this question is, it often seems to be forgotten that trillions of dollars of institutional cash is managed relative to market-cap bond indices. Rule-based investing is a great idea as long as the economic rationale, the anchor point and the rules are chosen smartly.
However, this is not the case for market-cap bond indices. First, because market-cap weights force investors into a few large, concentrated positions, and second, because investors have to trust highly-indebted countries to bring their budgets under control without creating too much inflation that would hurt investors in real terms.
Most academic textbooks introduce government bonds as a risk-free asset, and in practice, at least until a few years ago, government bonds issued by developed nations were indeed seen as virtually risk-free, with valuations dependent solely on interest rate policies.
Credit risk premia were required for corporate or emerging markets bonds, while the risks associated with developed countries hardly paid any significant spread. Today, many developed countries in their present constitution definitely no longer count as risk-free, and for some, credit spreads as well as perceived inflationary pressures have increased materially.
The results of Carmen Reinhart and Kenneth Rogoff from their seminal work ‘This Time Is Different' show that the higher a country's debt-to-GDP ratio, the more likely it is to default. At a ratio of 60%, countries, especially emerging countries, have faced trouble; debt-to-GDP over 90% acts as a significant drag on GDP growth - around 1% per annum has been observed across all countries.
The authors also point out that repayment of government debt based on economic growth rarely works and is tough in countries with unfavourable demographics. So the only solution is default, or an inflationary monetisation of debt.
In this spirit the chart visualises the risk of government bonds on the basis of two factors: the IMF expected debt-to-GDP ratio for a country in 2011; and its demographics based on the UN forecast of its old-age dependency ratio (OADR, which measures the ratio of non-workers to workers) for 2025.
The OADR serves as a proxy for the potential future workforce and for what Harvard economist and demographer David Bloom has called the demographic dividend, as well as for future social costs. The ideal situation for a bond investor purely according to this chart was a country with both low debt-to-GDP and low OADR.
The differences across countries are striking. For Japan and the European periphery, both measures paint a bleak future - these countries are highly indebted, and also face alarming demographics.
Other countries that dominate market-cap indices, like the US, Germany, France and the UK, all have disturbingly high debt ratios of 80-100% of GDP, paired, with the exception of the US, with worse than average demographic situations. On the other hand most emerging markets and some other developed countries are able to limit their debt-to-GDP ratios and have a demographic dividend ahead.
The intention of the figure is neither to be a tactical investment tool nor a quantitative input for portfolio optimisation. The main purpose is to offer a discussion basis for global bond investing in one big picture. The power of the figure lies in its simplicity, and in demonstrating how counter-intuitive market-cap bond investing is. Investors should ask themselves if market-cap weighting really is the best anchor point with the best set of rules for constructing and implementing global bond allocations.
Aside from risks and demographics, a look at returns is necessary. Today some of the most indebted nations offer record-low yields. The G7 countries, with the exceptions of Italy and Japan, offer 10-year yields between 1.7% and 3.0%. As long as investors don't expect the world to go to back to the Stone Age, those are not attractive risk premia, especially when real yields, representing potential inflationary pressures, are taken into consideration.
To be fair there are also a few arguments to defend the market-cap approach to bonds. First, it represents market liquidity pretty well. G7 bonds, especially US Treasuries, are more liquid than smaller countries' and often cheaper to trade. Of course the follow-up question to that observation is whether investors intend to trade their portfolios frequently and truly need that liquidity, or if they rather aim to collect the bond risk premia.
Second, not all countries' term structures allow for specific duration exposures. Third, some investors might prefer to invest mostly in liquid major currencies. Nevertheless, we can create a set of investment rules that addresses all three arguments and still solve the counter-intuitive approach of market-cap weights.
Based on economic intuition, we expect investors to assign high portfolio allocations to bonds with attractive risk-return profiles, where risks such as high debt-to-GDP ratios, inflationary pressures or weak demographics are compensated for.
Market-cap approaches based on outstanding debt can result in the contrary, because the most indebted issuers receive the highest allocations. We acknowledge that criticism of market cap bond indices started decades ago and many smart investors have already implemented better tailor-made rules for global bond investing.
Recently several index providers also introduced new sets of rules to take the countries' GDP, fiscal strength or global economic market share into account. We are supportive of these developments, which help investors choose a better investment anchor point, and a set of investment rules that allows for more efficient global bond investing.
Christoph Gort is a partner at SIGLO Capital Advisors