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 companies 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.
I would add to your analogy; “Imagine you have an active fund manager that skims 2% of your assets off the top in exchange for picking which nephew to loan your money to.”
Mawer Investments sells funds with low MERs. Their bond funds run at .73%, so not that much different than index bond funds. They have been trying to sell their products as active management at a near passive price. I am curious how they can make money at that, as passive managers theoretically would have less need for staff, letting algorithms do the decision making, for the most part. Or maybe the other active managers are just more greedy? Not sure if their returns are that much better or worse.
I know of Mawer only because the advisor at the institution I deal with was trying to sell their products to me, as he knows I am cheap.
Not that I own it, I have been sticking with Vanguard and iShares bond ETFs, much to the dismay of my financial advisor. Though I do regret having purchased Real Return Bond ETF (XRB), which was recommended in years past. It has taken a beating, though I am loath to sell it now, feel like I will just lock in the loss. That is a different topic.
@Chris: I don’t follow Bond funds very closely so I don’t know how Mawer’s bond funds stack up to Vanguard and iShares offerings in performance. I wonder why your financial advisor is showing dismay at your choice of bond funds as Mawer doesn’t incorporate trailer fees for advisors. Perhaps your advisor is genuinely concerned in your better interests.
That is a much more sensible analogy Dan. Great insight.
I’m a novice here, but isn’t the makeup of a bond index fund fixed, except for the replacement of maturing bonds with new ones? As the market and rate environment change, the fund fares better or worse, but it makes no adjustments in response to the changes, since fund management is passive.
In contrast, an active bond manager can shift between short and long, corporate or government, Canadian or US or international, as the anticipated or actual circumstances change.
Wouldn’t management that adapts to a changing environment be better inherently than true passive management? And, if so, by how much, relative to the MER?
Looking for some enlightenment here…
If index funds had a big problem with credit risk, they would have performed poorly in 2008, the worst year for credits since the great depression. But in fact, the iShares Canadian Universe Bond ETF (XBB) returned 6.13% that year…far from a disaster. Even if one looks at the iShares Canadian Corporate ETF (which has a lot more credit risk), it returned -0.60% in 2008, only to return +15.10% in 2009. These statements about index bond so-called flaws are not supported by evidence.
Very nice post and analogy, Dan. As one would have expected a CFA to understand this point about bond funds, one might be excused for wondering if the post was just another attempt by the active management industry to scare people out of passive indexing into their domain.
@Chris: I wouldn’t call .73% for a bond fund not that much different than index bond funds. VAB, for example, has an MER of 0.14%, 5 times less expensive. Even a difference of as little as 0.5%, all else equal, results in 14% less wealth after 30 years, due to the effects of compounding.
@Bernie: As the best predictor of fund performance is cost, I would have thought that if Chris’s advisor really had his best interests at heart, he would have suggested Chris stay with his bond ETFs.
About Raymond’s comment, the Canadian bank rate fell by over 4% from late 2007 to early 2009. That should be the reason for the nice lift in Canadian bonds through the great recession, since it’s certainly enough to overcome any defaults in Canada. But I think the main risk of default lies in high yield bonds in developing markets, or so I understand from the recent IMF warning. I’m a novice in this stuff, though.
I disagree with the arguments made in this article. Here is why:
1. “Plain-vanilla bond indexes include only investment grade bonds, which have an extremely low likelihood of default.”
– This ignores the fact that bond rating agencies have a horrible track record of assessing risk and making ratings. For instance, S&P, Moody’s and Finch rated many mortgage backed securities as the safest investment (highest rating) leading up to the 2008 crisis. S&P were subsequently charged with fraud. However, the problem has not been solved… credit ratings are almost meaningless because under stress then change in an instant once new information comes to light.
2. Bond rating agencies don’t take currency risk into account. However, one cannot ignore the problem of currency which is comingled with interest rates and debt in general. Right now people aren’t talking about the possibility of a rate hike in the US because 0.25% means anything significant by itself. Instead it’s meaning and significant when it is compared to the rest of the world and the resulting capital flows that will follow. Already, it’s had a big impact… e.g. Canada has seen huge capital outflows and the US dollar has appreciated. The bond rating agencies would have said that Canadian bonds and US bonds were both investment grade and yet they had wildly different returns!
Just like in 1989 in Japan, the best strategy for a Japanese investor would have been to invest abroad, not in their local currency.
Anyway, I live what I speak. I switched my bond holdings to US dollars (cash) over a year ago because I don’t believe in the tooth ferry and I knew Canada was in trouble and I knew long bonds were a fools game right now. I’m not Nostradamus but it’s pretty clear that many countries will be screwed when the US starts raising rates. In their currency is not decimated their credit rates will be when they are forced to raise interest rates.
Dont like the idea of bond mutual funds being touted as super safe. This article confirms to me what I already knew.
GIC’s are becoming more and more part of my fixed income. Hard to do well with bond funds with the high mer’s they have. Fees are a huge factor in canada as we all know
@Tristan: “As the best predictor of fund performance is cost…”
So the theory goes. Unfortunately, the prediction often doesn’t come to fruition.
@Bernie: I don’t think my financial advisor is a bad guy at all. I know he has some faith in active management. The company he works for pays salary, not commission.
@Tristan: The fees for ETFs are lower, like VAB. I am suggesting that compared to other mutual funds, including index funds that isn’t high. TD Canadian bond fund (non-E series) is .83%, RBC Bond is .67%.
I am curious why the index funds need to charge that much compared to ETFs.
I think you’re missing one of the main points of the article, which is that cap-weighted bond funds may have risk characteristics individual investors don’t fully appreciate. For example, the DEX Universe Bond Index is 25% CMHC and Ontario debt. Likewise, Japan and France are roughly 29% of most cap-weighted bond indexes. As long as people realize this is what they’re buying, then that’s fine. But I think most people would be surprised by the level of concentration in their bond portfolios among entities whom may not necessarily remain in the realm of investment-grade forever.
@TheOtherChris, well said. Even I didn’t realize that the DEX Universe Bond Index is 25% CMHC and Ontario debt. Not debt I want to personally hold! Very, very scary when you consider that housing prices in Canada are in a bubble and that Ontario is the world’s most indebted sub-sovereign borrower. Even more scary when you look at the capital outflows that are happening in Canada (they are the fastest outflows in the developed world!)
We’re in scary, scary times right now and hardly anybody even knows it.
I’ve radically lowered my investment exposure to Canada and I thought I might have been a bit extreme… but every indicator I see just reconfirmed my choice. Only time will tell though.
@Steve: from your apparent cynicism regarding gratuitous backtesting fortified by hindsight, would it be fair to extrapolate that you profess agnosticism about the future, at least in a pragmatic sense (i.e. no active management), and espouse the classic Canadian Couch Potato passive index investment model with no frills.
Or do you too have a secret sauce?
No, not the way I meant it, which was in the ironic sense (one’s secret sauce is usually gobbledegook for some sort of active management); you just confirmed what I thought — you’re essentially a couch potato.
Regarding your “asset classes on sale” comment, an insight I acquired this past year was that rebalancing was less about “buying low” (which, indeed, might well be a by-product) and more about re-adjusting overall asset allocation (IF NECESSARY) back to within comfortable limits.
Running with the herd doesn’t require any great skill. Not running with the herd (i.e. not believing the collective wisdom of the experts of the financial world regarding future predictions) is much more difficult, which is why most people stray in some way or other from the True Path of Spud-dom. Having finally found the Way myself, I still continually have to struggle to stay on the straight and narrow.
There should be a 12-step program to unburden myself whenever I am tempted to stray. Prognosticators Anonymous.
Dan – as usual some great thoughts on this issue. If I may, I’d like to add a couple of thoughts.
First is that I think there are good points on both sides. A large dollar amount of debt, by definition, means the issuer is large. You cited Berkshire Hathaway as a corporate example; and the U.S. for government. In other words, largest debt issue doesn’t necessarily equal highest debt ratios. But Japan is a case where they have a big weight in bond indexes and have the highest debt/GDP – and razor thin yields to boot. Not so encouraging when your international bond fund has 15% or 20% in the most highly indebted issuer with the lowest yield bonds.
Second, does Vanguard actually offer a true global bond ETF? I saw U.S. and international but not global. The only global bond index fund I know of is from CIBC – and if you pony up at least $50k you’ll get the fund at about 40 basis points annually.
Finally, I don’t know that there is a perfect solution to the ideal bond index but it’s at least worth exploring the ideas put forth by Research Affiliates in terms of their view on traditional bond indexes (similar to Mawer) and how they address the weaknesses of traditional indexes.
@Dan: Thanks for the comment. I can certainly understand the decision to avoid bonds from a country where the yields are very low when you can get a higher yield and comparable (perhaps better) safety elsewhere. That’s just a simple risk versus reward question. I just push back against the idea that bond index funds are more risky because of their structure. The Mawer blog explicitly argues that traditional indexes overweight issuers with “typically the worse credit profile,” which isn’t accurate, even in the case of Japan, unless one believes that Japan is likely to default on its debt.
You’re right about Vanguard: to get global bond exposure you would need to own two ETFs: VBG and VBU. With many of our clients we use the DFA Five-Year Global Fixed Income, which has a fee of 0.39%, is fully hedged, and has the added benefit of being quite tax-efficient.