Imagine that the stock market was divided into two. The big investment banks — Goldman Sachs, Morgan Stanley and Bank of America Merrill Lynch — would create lists of the shares that they liked. These approved shares would be classed as IB, for investment-bank-approved, and would trade on a higher valuation (i.e., lower yield) than equities they did not like, which would be lumped together in the BS, or bank-shunned, category. Some investors would be prevented from owning anything but the IB shares.
The idea sounds bizarre, but such an artificial distinction does exist in the bond markets, where the big ratings agencies class debt issues on a scale from AAA, the highest class, to D, for bonds in default. Bonds rated BBB- or higher are classified as investment grade (IG) whereas those rated BB+ or below are regarded as speculative, or more popularly, junk bonds. Some investors will not touch junk bonds at all; most bond funds focus on either IG bonds or junk.
But as Kevin Corrigan of Lombard Odier Investment Managers points out, this Manichean divide is rather odd. The difference between the BBB and BB categories is not that fundamental. Figures from Standard & Poor’s, one of the big ratings agencies, show that, of American corporate bonds rated BBB, 1.1 percent are in default three years later; for those rated BB, the figure is 4.8 percent. By contrast, 14.7 percent of bonds rated B have stopped paying within three years and 41.7 percent of those rated C or below. The figures for European bonds are similar (see chart).
A degentrification has been taking place in the bond market. The aristocrats of bonds — issuers of AAA-rated debt — have virtually disappeared. There is no longer much of an advantage in being rated AAA: shareholders instead want companies either to return the spare cash that might help earn them a high rating or to make their balance-sheets more “efficient” by borrowing more to take advantage of the tax deductibility of interest payments, thus jeopardizing an exalted status.
Instead, most bonds are lumped together in the middle. Around 68 percent of European junk bonds are rated BB, while BBB bonds make up about 44 percent of the investment-grade category. Again, an artificial division between the two seems odd: surely the idea is to pick the most attractive bonds, whatever the category?
Another strange aspect of investing in bonds is that indices are weighted by the value of bonds outstanding; in other words, the most indebted companies have the biggest weight. When Verizon, an American telecoms giant, issued $49 billion of debt last September, it automatically became a prominent fixture of corporate-bond indices.
Although this seems in keeping with the approach used for equity indices, it is fundamentally different. As George Cooper, a fund manager and author, describes it, “An equity benchmark is asset-weighted, a bond benchmark is liability-weighted.” It is like lending most of your money to your least responsible friend.
In 2010 Ramin Toloui of PIMCO, a fund-management group, calculated that government-bond indices weighted by GDP had outperformed those weighted by value over the previous 20 years (and with less volatility along the way). Corrigan suggests the same approach can be followed for corporate-bond indices: the weighting in the index can be based on the industry’s contribution to GDP rather than the debt in issue. Such an approach tends to reduce the weighting in banking and utilities compared with a liability-weighted benchmark.
The idea of alternative weightings for indices has been around for a while in the equity market, and is known in the jargon as “smart beta.” It is based on two underlying hopes. First, a market-value-based weighting system involves a bigger exposure to shares that have risen in price and a smaller exposure when they have fallen — the equivalent of buying high and selling low. Alternative approaches may avoid this problem. Second, fund managers who outperform the index may do so by looking at other factors — for example, stocks that look cheap relative to their dividends or assets. A smart-beta approach can capture such factors without charging the high fees demanded by the industry.
It makes sense for such ideas to be extended to the bond market. As the rich world ages and more people depend on private pensions for retirement income, bond funds will become increasingly popular. But with bond yields low, charges will eat into investors’ returns. Cheap ways of buying diversified portfolios of corporate bonds will be needed.
© The Economist Newspaper Limited, London (February 8, 2014)