Bond indices flaws could leave investors exposed
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Bond indices may be exposing investors to greater risk because of a flawed structure.
Jeff Molitor
Indices that allocate weighting on the volume of outstanding debt rather than the ability of the issuer to repay could find themselves becoming skewed towards the most indebted countries or companies.
“I think the concept began in equity markets where the higher the market-cap of a company the bigger its weighting in the index, but it spread to fixed income,” says Patrick Armstrong, the joint managing partner at Armstrong Investment Managers. “However, with bonds it has the reverse correlation with risk.” (article continues below)
Taking the eurozone as an example, Citigroup’s Euro Government Bond Index allocates a quarter of its weight to Italy, rated BBB- by Standard & Poor’s, but just 21% to AAA-rated Germany. As at the end of last year Germany’s net debt as a percentage of GDP was 51.5% versus 100.2% for Italy.
Jeff Molitor, the chief investment officer (Europe) at Vanguard, says if investors are concerned about the risks they can use indices that eject bonds if they fall below a certain rating. Given that the quality of credit tends to deteriorate relatively slowly this should provide protection against a credit event but there are potential pitfalls.
“[These indices] would take a substantial drop at a downgrade if it was unexpected by the market and there was a significant weighting of the downgraded debt in the portfolio,” he says.
To better reflect the underlying risk, Armstrong suggests that investors look at alternative benchmarks such as those which allocate their weightings based on GDP.
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