The trouble with bond indices

In the 1980s, Japan was on fire. The country’s impressive economic growth convinced many Americans that they’d have to adopt state-directed-capitalism just to keep up. Acclaimed books such as “Japan as Number One” by Ezra Vogel of Harvard, and “The Japan That Can Say No: Why Japan Will be First Among Equals” by Shintaro Ishihara and Sony co-founder Akio Morita predicted Japan’s inevitable economic dominance. American parents spoke seriously about the need to teach their children Japanese.

But this economic fairytale was short-lived. By 1989, Japan’s massive real estate bubble burst, throwing the country into a decades long battle with deflation that it has yet to kick. Yields on Japanese government bonds spiked above 8%—a stark contrast from the 2.5 to 6% range they held throughout the mid to late 80s. Asset prices plummeted. It was a stunning denouement for a country that had been slated to take over the world.

Japan’s crash in 1989 and its subsequent economic woes have provided policymakers and investors with many cautionary tales, but one in particular is usually overlooked. Japan’s credit profile was not great leading up to the crash, and since then it has worsened. Yet Japanese bonds—both then and now—make up a significant weight in the major global government bond indices.

This is a good example of a structural flaw in bond indices. Even though Japan struggles with deflation, is burdened by an aging population and huge welfare commitments, runs persistent deficits and has a general government debt-to-GDP of approximately 240%, the country accounts for as much as 25% of the two major global government bond benchmarks. In other words, a weak debtor receives a large weight in a major bond index and then gets to benefit from the capital that this attracts.

This occurs because, like most equity indices, bond indices weigh themselves on size. Except where the constituents in equity indices are weighted based on their market capitalization—which at least theoretically makes sense—the participants in a bond index are weighted based on the size of total debt—which is a lot less ideal. 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).

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.

This weighting system is why Italy is a larger constituent in the European government bond indices than the much less indebted Germany. It is why a country in such a difficult long-term fiscal position such as Japan could make up as much as a 25% of the major global government bond benchmarks. For context, we hold Japan at a 2% weight in our Global Bond Fund.

The problem with this rigid rules-based system is the risk it introduces. Most individual investors hold bonds in their portfolio to earn a steady stream of income and for their defensive characteristics. They are not looking to generate outsized returns in the bond market through pricing anomalies; they want quality bond issuers that offer a reasonable yield for a given level of risk. But if these investors were to buy and hold a passive bond index for stability, they would be investing in a potentially less optimal solution.

Two things are worthwhile to remember here. First, the mechanics of a system matter for passive strategies, so if you are going to be a passive investor, spend the time to ensure you understand the underlying structure of what you are buying. ETFs and passive strategies are rules-driven strategies. To understand the amount of risk you are undertaking, you need to understand the rules of the game.

Second, the mechanics of how most bond indices are constructed can increase the level of risk. If you are looking to add stability in your portfolio by investing in a passive strategy that follows a bond index, be aware of the way bond issuers are weighted in most of these indices. You may want to consider other options.