Fundamental Indexing for Corporate Bonds

On Monday, I took issue with the argument that cap-weighted bond indexes are fatally flawed. Rob Arnott, the creator of fundamental indexing, has argued that the classic model is “patently ridiculous.” The Research Affiliates website frames the problem like this: “Traditional bond indices give their greatest weights to the biggest debtors. Should investors buy more of a company or nation’s debt solely because it increases its issuance?”

My previous post looked at this idea as it applies to government bonds. However, there are currently five RAFI fixed-income indexes, and all of them cover corporate debt—three for investment-grade bonds, and two for high-yield bonds. And right now there’s just a single ETF tracking one of these indexes: the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB). This fund has been around since 2007, though it didn’t start tracking the RAFI High Yield Bond Index until last August.

The other side of the argument

In a recent conversation with Steven Leong and Oliver McMahon, who handle product management for iShares, I brought up the idea that traditional bond indexes overweight companies with the most debt. On the surface that is true, but it totally ignores the size of the company relative to the size of the debt,” Leong said. “It should surprise nobody that a company like Royal Bank has issued more debt than a company like Shoppers Drug Mart, for example. Nor should it be something that anyone is afraid of.”

Remember, companies don’t necessarily borrow for the same reasons that consumers do. When we get a loan to buy a house or a car, it’s because we’re simply not able to pay cash. Yet just this month Google issued $3 billion in bonds despite having some $35 billion in cash reserves.

“If a company’s internal rate of return is higher than the interest they pay on their bonds, it’s smart for them to issue more debt,” McMahon explained. “They’re creating value for their shareholders. An alternative might be for them to issue more stock, and that’s not always a sensible thing to do, because you’re going to dilute the value of the existing stock. You definitely can get to a stage where you issue too much debt. But the simple fact that a company has a large amount, in and of itself, is not indicative of a problem.”

No regard to fundamentals?

The RAFI website states that “traditional bond indices weight issuers solely by the market value of each firm’s outstanding debt with no regard to underlying firm fundamentals.” As I argued in my earlier post about sovereign debt, this isn’t quite true. Bond indexes funds always screen for credit risk. So if a company is drowning in debt and has little capacity to pay it back, its bonds will get a junk rating and they won’t make into indexes that hold only investment-grade issues.

If you want to avoid companies with bad fundamentals, all you need to do is buy an ETF such as the iShares DEX All Corporate Bond Index Fund (XCB), the Claymore 1-5 Year Laddered Corporate Bond ETF (CBO), or one of BMO’s corporate bond ETFs that hold nothing rated lower than A by Standard & Poor’s. The likelihood of a bond defaulting in any one of these bond funds is very low.

Using a fundamental index for a high-yield bond fund seems to make more sense, since the likelihood of default is much greater. The RAFI High Yield Bond Index includes nothing less than BBB, whereas more than 14% of the iShares U.S. High Yield Bond Index Fund (XHY) is rated CCC+ or lower. “RAFI corporate bond strategies will tend to have higher credit ratings than their market-weighted counterparts,” the website confirms. Of course, lower credit risk may also mean lower returns. Both PHB and XHY have similar durations, but PHB’s yield to maturity is almost a full percentage point lower.

During his recent talk in Toronto, Rob Arnott said, “I think fundamental indexing in bonds is going to be bigger than it is in stocks.” I’m not at all convinced of that—the RAFI strategies seem to offer far more potential in equities. US investors, however, do seem to be receptive: PHB has more than doubled its assets from $202 million before the index change to about $480 million today. (Although for some perspective, its iShares counterpart holds $9 billion.) PowerShares also has an ETF in the works that will track a RAFI index of investment-grade corporate bonds.

Canadians will get a chance to vote with their money soon enough: last month, Invesco announced that it plans to launch a version of PHB on the Toronto Stock Exchange, this one hedged to Canadian dollars.

5 Responses to Fundamental Indexing for Corporate Bonds

  1. Christian May 26, 2011 at 9:40 am #

    Interesting read, especially timely since i am currently reading The Big Short, which is a book detailing the lead up to the financial crisis of 2008 and the parties involved. Now what factors big in this story is the utter stupidity with which Moody’s and S&P rated the CDOs or bonds that were packaged by the big investment banks. -BBB and AAA really didn’t have much of a meaning, all the ratings agencies were concerned with was pushing through the debt and making money for doing so. Also, it became apparent that the bond world was, maybe still is, much more opaque than the stock world. How do you know what you are holding? And I mean what you are really holding. How do you know the terms of these contracts?

    I don`t know if the ratings agencies have since changed their mode of doing business, but from what I read the bond world is a whole other ball game. However, it is true that much of the scandal involved packaged home loan debt as opposed to corporate debt, but nevertheless it is still quite confusing to know exactly what is held in these bonds. And if things aren`t transparent how do you know what you are investing in?

    Thanks,
    Christian

  2. Canadian Couch Potato May 26, 2011 at 9:56 am #

    @Christian: Thanks for the comment. I’m no expert on the rating agencies, but I think the CDO fiasco was quite unique. These products were so opaque that the rating agencies must have had no idea what they were trying to assess. That doesn’t excuse them from screwing up, but my point is that I would expect their ratings to be much more accurate when it comes to plain vanilla corporate debt. Bonds issued by large companies are pretty uncomplicated.

  3. Christian May 26, 2011 at 11:27 am #

    @Dan. I realize that the sky is not always falling. That is not what i am trying to imply here. However, I do think that the bond world is more opaque than the stock world. If you wanted to find out what your etf bond held could you, if you wanted to find out the terms of the bond could you etc.?

    thanks

  4. Canadian Couch Potato May 26, 2011 at 11:50 am #

    @Christian: I’m really not sure what one would have to do to learn about the specific terms of a corporate bond. However, I do know that using a different methodology to weight a bond index fund does nothing to change this.

  5. christian May 26, 2011 at 1:00 pm #

    For instance, are the bonds within the ETF callable? If bonds get downgraded does the etf trade out of them, etc..?

    Have a look at this article, http://www.huffingtonpost.com/2011/02/09/end-of-credit-rating-agen_n_820626.html I don’t care whether or not you publish it, but nevertheless it is an interesting read.

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