The trouble with bashing bond indexes

In my last post, I looked at a tired criticism of traditional equity index funds. Similar arguments have been made against fixed-income index funds, most recently in a blog post called The Trouble With Bond Indices produced by Mawer Investment Management. And once again, they don’t hold up to scrutiny. First the background. Bond indexes, like their equity counterparts, are usually weighted by market capitalization. This means governments and companies that issue the most bonds (by dollar value) receive the largest weight in the index. Most index investors in Canada use funds that include only domestic bonds, and typically these are roughly one-third federal government bonds, one-third provincial and municipal bonds, and one-third corporate bonds. Global bond index funds are much less common in Canada (only Vanguard offers an ETF in this asset class), but the principle is the same: countries that issue the most debt receive the greatest weight in the index. You may have already spotted the potential red flag: the more debt a country or company has on its books, the more of its bonds you’re likely to own if you use an index fund. Since we’re accustomed to seeing debt as inherently bad, this seems like a terrible design flaw. As the Mawer blog puts it, “a weak debtor receives a large weight in a major bond index and then gets to benefit from the capital that this attracts.” The author goes on to use a variation of the analogy everyone uses when making this criticism:

For example, imagine you have two nephews. The youngest nephew is a disciplined student in university with a part-time job at the local campus. He has no debts, pays his own tuition, and has never come to you to borrow money. In comparison, the eldest nephew is reckless, has no job, and owes a couple of thousands in credit card debt racked up from partying. If both of them came to you to borrow money and you followed the line of reasoning of most bond indices, you would be forced to fund the older and much less creditworthy nephew.

Giving credit where it’s due

Problem is, this analogy implies that a country or company that issues a lot of debt is fundamentally less creditworthy. Indeed, the Mawer blog explicitly lumps these two qualities together: “In a bond index, the debtors with the most debt, and typically the worse credit profile, make up the most of the index (you would hope for the reverse).” But this is a specious argument. The largest issuers of debt are—not surprisingly—populous countries and big companies. The United States has issued an awful lot more bonds than say, Somalia, but which do you think are more likely to default? The bonds issued by Berskshire Hathaway dwarf my MasterCard balance, but that doesn’t make me more creditworthy than Mr. Buffett. The amount of debt, in and of itself, doesn’t tell you very much at all: a credit profile must also consider the issuer’s assets and ability to finance the debt. Countries and companies do not necessarily issue debt because they are “reckless, have no job” and prone to “partying.” Governments issue bonds so they can finance their current liabilities and pay for them over time—a luxury they can easily afford because they can levy taxes on their citizens. Meanwhile, profitable business frequently sell bonds because the interest rate they pay is lower than the return on the capital they raise. Apple, for example, recently issued a new round of bonds, bringing its debt total to $55 billion. They didn’t do this so the executives could go on a bender: they issued the bonds because they pay less than 2% interest, and Apple can make much more than that by using the $55 billion to sell you iPhones.

A better analogy

If you’re going to make an analogy, here’s one that better reflects how a bond index is constructed:

Imagine you have two nephews. The youngest has a well-paying job, spends within his means, pays his credit cards each month and has no other debt. He rents a one-bedroom condo and has $50,000 in his RRSP. In comparison, the eldest nephew owns a successful business that generates $1 million in annual revenue. This nephew earns a high income and owns five investment properties worth a total of $3 million, with about $1 million in mortgage debt. If both of them came to you to borrow money and you follow the line of reasoning of most bond indices, you would probably be willing to lend money to both, given that they are both equally likely to pay you back. However, the older nephew has far more capacity to borrow, because he earns a much higher income and has a dramatically greater net worth, so you would lend him a lot more.

Of course, many countries and countries issue more debt than they can reasonably be expected to repay. But those issuers won’t be in a traditional index fund. Plain-vanilla bond indexes include only investment grade bonds, which have an extremely low likelihood of default. If you want to take additional risk in search of bigger yields, you can invest with the reckless nephews in high-yield bond index funds, which are specifically designed to expose you to more credit risk. These indexes do exactly what they were designed to do, which is give investors the ability choose as much or as little risk as they want with their bonds. There’s no “structural flaw” that disguises that risk. Bond indexes, like their equity counterparts, are imperfect, but they are not inherently riskier than active bond funds. It’s irresponsible to suggest otherwise. This article was originally published at canadiancouchpotato.com.