If you think about it, a bond investor is lending money to whoever is issuing the bond. So the biggest risk is not being paid back capital when the bond matures, and not receiving the interest payments in the meantime.
Traditional bond indices fly in the face of this because they tend to give a higher weighting to the bond issuers according to how much they have issued. It’s similar to a bank manager lending more to a customer simply because they have already borrowed plenty – that’s the approach traditional market capitalisation indices take.
The combination of this approach and the recent huge appetite for borrowing by countries and companies means bond investors are now facing a clear and present danger. Sovereign bond indices today are concentrated on the most indebted countries while sounder economies such as the Nordics are underrepresented. It’s the same for corporate bond indices, where market-cap benchmarks are over-exposed to highly leveraged sectors, such as financials, regardless of the contribution they make to the economy.
But this is not new. The 2008 financial crisis and subsequent European debt problems meant massive losses for investors’ portfolios, and shot holes in Sharpe ratios. This led some investors to question the merits of traditional approaches and look again at bond risk in general.
Since 2010, new fixed income investment approaches have been developed that are based on assessing the financial strength of bond issuers. Building bond indices this way reflects the creditworthiness of borrowers rather than their issuance. Recently smart beta bond ETFs have brought this approach to a wider range of investors that are looking for the liquidity and lower costs of ETF investing.
Hungary is one such example in this alternative approach. It has a big weight in the market-cap index, due to its large outstanding debt. Its indebtedness increased from 53 per cent of GDP in 2001 to 80 per cent of GDP by September. A fundamental approach halves the weighting because of this debt and Hungary’s high old-age dependency ratio.
The fundamental approach generally gives a higher weighting to larger countries, which are deemed more capable of paying their debt. It looks at a country’s debt burden, both domestic and external, and its government budget current account deficit or surplus. It also examines if the public finances are improving or worsening, and tracks social and political stability. If social imbalances are not contained they can lead to debt defaults such as in Russian in 1917 or Argentina in 2002. On top of this, old-age dependency can eventually result in a surge in public debt as governments shoulder the burden of old age care.
On the company side a similar approach is used for fundamental strategies.
Not long ago banks and insurers made up nearly half of the investment grade corporate bond index. In September 2008, the collapse of Lehman Brothers triggered a 15 per cent fall in corporate bonds issued by financial companies, which meant investors suffered swingeing losses thanks to their overexposure to an overborrowed sector.
The fundamental approach also sizes sectors relative to their contribution to wealth creation within an economy. It then looks at the financial strength of the company issuing the bonds and weights it accordingly. Even now, global investment grade bond indices have a 32 per cent weighting to financials, compared to a fundamental weighting of less than half that. At the other end of the scale, the retail sector, which represents around one-quarter of the global economy, represents just 11 per cent of traditional market-cap bond indices.
However, a downside of the fundamental approach is that it can have a natural tendency to be more defensive, and therefore underperforms during a bond bull market. Conversely it is also likely to bring better risk-adjusted returns, and limit losses when bond markets are under pressure or facing a liquidity squeeze. Ultimately it’s down to investor preferences.
Traditional bond indices tend to overallocate to the most indebted nations and companies, which may harm portfolios in a crisis. A fundamental approach looks deeper into the company or country to allocate based on fundamentals, but it may underperform in a bond bull market.
Kevin Corrigan is head of fundamental fixed income at Lombard Odier Investment Managers.