“The market’s up today.” What do we mean when we share that bit of news? Usually, it’s the U.S. stock market we’re referring to, and almost always a proxy for that market—the S&P 500 Index or Dow Jones Industrial Average, for example.
Stock and bond indexes are central not only to how we measure performance but to how we capture it, via active funds benchmarked to an index or index-tracking mutual funds and exchange traded funds (ETFs).
We rely on these “market-value” indexes because they’re transparent and easy to understand. They are essentially lists of securities whose weights are set by what they’re worth in the market. For stocks, it’s the number of a company’s shares outstanding multiplied by its price. For bonds, the approach is the same: Individual weights are determined by the principal amount of the bond outstanding multiplied by the bond’s price. The higher the market value, the larger the index weighting.
This should be pretty straightforward, but some people think bonds are different. Their reasoning is that, ‘bonds are debt instruments, so market value-based bond indexes skew toward issuers with larger debt sizes; therefore, bond indexes are riskier.’
Some kind of fallacy
Here’s why the logic is flawed. It’s true that issuers with larger debt size have larger representation in the index. That makes sense: They represent more of the market and the investable opportunity set. But it doesn’t necessarily follow that their large debt issuance makes the index or any individual issuer more risky. Size does not equal risk.
The largest issuer in the Bloomberg Barclays U.S. Aggregate Index is the U.S. government, yet the market does not assign material credit risks to these bonds (source: Bloomberg, as of 10/16/2017). The top issuers in the Markit iBoxx US Dollar Liquid Investment Grade Index include quality firms like Verizon, Microsoft, JPMorgan Chase, Bank of America and Apple (Source: iShares, as of 10/16/2017). Indeed, the five largest corporate bond deals of all time include offerings from Apple, AT&T and Verizon. Their larger debt issuance does not inherently reflect higher issuer risk.
In fact, large companies with large debt loads can be (and often are) financially healthier than smaller companies. The table below—which shows the 10 largest and smallest issuers in iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)—makes this abundantly clear.
Higher quality issuers that are able to tap the debt markets in scale generally do so because the soundness of their balance sheet allows it. These issuers may be awash with cash, have low leverage or a rich portfolio of intellectual property or other earning assets. Larger debt issuance typically comes with a larger pool of assets and equity market values. Ultimately, a bond ETF’s performance will be dictated by the mix of its exposure to interest rates, credit spreads, currencies, credit quality and slices of global bond markets. It doesn’t fit to always equate debt size with risk.
Weighting a basket of securities by market value has been the industry standard for decades, and for good reason. This type of indexing often reflects the liquidity and market capacity for an asset class, which enables them to be replicated for investors—efficiently and at a low cost.
That said, today’s bond indexes—and bond ETFs—go well beyond market value weighting. Some indexes cap issuers by size, others cut the market by yield or maturity dates. Advances in bond indexing are starting to arrive with screens for credit quality relative to yield; rate and currency hedging; volatility management; and more controlled exposure to interest rates and credit spreads. We’re just at the beginning of a new era for how we build our bond portfolios.
There are nearly 1,000 bond ETFs giving investors a rich palette to manage risk and return in a portfolio. Take a closer look at these ETFs, and focus less on the debt size issue.