The Problem With Investing in Bond Indexes (EP.99)

0:22Welcome to The Long-Term Investor. A few weeks ago in episode 97, I laid out why bond funds are superior to individual bonds. This week, I'd like to dig a little deeper into bond funds and highlight some of the shortcomings of bond index funds. Let's back up a little bit. If you follow much of my writing or podcasts, you know that I firmly believe that active management is a losing proposition for stocks. I have all sorts of blog posts, podcast episodes that I can link to in the show notes at the longterminvestor.com to give you as little or as much of an explanation on why active management doesn't work for stocks.

1:02But bonds are different in stocks in a few important ways that make investing in bond index funds suboptimal, in my opinion. For starters, not all bond investors are total return oriented. In fact, more than half of the 100 trillion plus global bond market is controlled by what I would refer to as non-economic investors. So you have central banks that make up about 22 % of the market, along with other banks and insurance companies that are around 32 % of the market, all of which are non-economic investors that typically have objectives other than generating the most possible return. Central banks, for example, they may buy bonds to weaken their currency or boost inflation and asset prices.

1:46Commercial banks and insurance companies, they may care more about book yield or credit ratings than total return. And the result is that over half of the bond market participants aren't necessarily concerned with maximizing return. And that is very different than equity markets. The other part about bond indexing that bothers me, when you look at the Bloomberg Barclays Aggregate Bond Index, or the AG as it's often referred to as, it has a lot of shortcomings of its own. Whenever you see a total bond market index fund, it's typically tracking the AG. And look, if you own the AG in your bond portfolio for multiple decades, you'd probably do just fine.

2:26But there are two big reasons that using a bond index doesn't feel all that intuitive to me. The biggest problem I have with bond indexes like the ag is that bond indexes are weighted towards issuers with the most debt. So with traditional stock indexes like the S &P 500 or the Russell 3000, those are weighted by market capitalization. That means the bigger the company, the bigger its position in the index. And successful companies with increasing equity prices see their equity weightings increase as a percentage of the market index. So you could argue that the size of a company's weighting in the index is an indicator of its success.

3:05But that's not the case with bonds. The largest components of the ag or any bond index are the issuers with the most debt outstanding. In other words, companies or agencies see their weightings in the bond indexes go up as the debt issuance increases. And there's just something about that that seems off to me. I mean, having a lot of debt doesn't necessarily make an issuer a better bond investment. It just means they have a lot of debt. The second problem that I have with the ag specifically is that it's highly concentrated in US government exposure. So when you hear that the ag is composed of over 12 ,000 bonds worth more than$25 trillion, you probably assume that it's very well diversified.

3:50But as of 2022, treasuries made up 40 % of the ag. And when you factor in debt issued by government agencies and mortgage-backed securities, the total government exposure is now over 73%. Plus, the historical correlation of U.S. treasuries and mortgage-backed securities is 81%, meaning that historically, the returns of those sectors have moved in the same direction most of the time. Meanwhile, less correlated sectors either form a much smaller component of the ag or in the cases of sectors like U.S. corporate high yield and emerging market bonds, they're just not represented in the ag at all. So if I don't like bond indexes, does that mean I think active bond management is better?

4:35Well, yes and no. Cost remains incredibly important. There are a growing number of systematically managed fixed income products that are low cost and rules based, which are the two primary characteristics that make equity index investing so successful in the first place. Now, the rules driving systematic fixed income manager decisions typically revolve around the shape of the yield curve, differences in credit spreads or currency valuations. But then there's also the traditional active management bond funds where analysts pick and choose bonds based on their analysis of its expected return. and you're typically going to see higher costs with this style of bond investing, but that's not always the case.

5:15These days, you can find active bond funds with index-like cost structure. Core bond funds, for example, are often so cheap that it's easy to assume it's a passive fund. And oftentimes, those managers are taking advantage of rules-based processes while also enjoying the benefits of active bond management. For example, the composition of bond indexes changes pretty frequently. And when fixed income securities join or leave an index, their prices tend to rise or fall as passive investors rush to buy or sell. Whereas active investors, they can anticipate and profit from these changes. Another area of note is that bonds, unlike stocks, mature after a number of years, leading to more turnover in the bond market.

6:00New securities make up about 20 % of bond market capitalization annually compared with about 1 % in equity markets. And I think the important part of this is that bonds are typically offered at concessional pricing to drive demand. And yet, these discounts are generally not available to passive managers who tend to buy new securities when they join an index, often a couple of weeks after they've been issued. So in short, bonds are a bit different than stocks when it comes to indexing. To recap, the two biggest reasons being that over half of the bond market investors aren't concerned with maximizing total return and the rules governing a bond index reward the most indebted entities rather than the most successful ones.

6:45For show notes and resources, please head over to the long-term investor.com. Thanks as always for listening and until next time to long-term investing.

6:58Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.