Bonds are different.
Fads come and go in finance. Value investing is in, then it’s out, then it’s back in. Global investing is out right now, mainly because it’s underperformed the US for so long. Sometimes fads and fashions have a permanent impact. This has been the case with index funds. A stock-market fund that holds everything in proportion to the company’s market size makes a lot of sense, and it’s the closest thing to a market-neutral portfolio that anyone has been able to figure out.
But bonds are different. They don’t go up in value as a company gets bigger, they remain fairly stable until they mature. And while a few stocks win big over time, becoming five or ten baggers – Apple, Amazon, Nvidia – the best a bond ever does is pay interest and then go away. Most bonds don’t trade on an exchange. They depend on dealers to make a market.
But bonds are important for the economy and important for investors. Constructing a bond index, therefore, is a challenge. You want to include everything meaningful, without getting too deep in the weeds. Bond indices answer this question by being issuance-weighted. The more of a bond that’s sold in the market, the heavier its weight in the index. That has a real advantage for index providers and investors: the biggest issues tend to be the most liquid and the most readily available for purchase.
But there’s a problem: the “bums” problem. The biggest issuers are the most indebted issuers. They’re the ones most likely to get into financial problems. The financial crisis wasn’t a problem because housing prices fell. It was a problem because lots of people defaulted on their mortgages, and that sent shockwaves through the economy. Lots of bond indices were exposed to these bums, as they issue more debt whenever there’s a problem brewing in the economy. The bums rush in to lock in financing, and index investors get stuck owning bonds issued these bums.
Sovereign bums: notice Argentina in the ‘90s? Source: Swiss CFA Society, JP Morgan
Bond investing is the ultimate loser’s game: people don’t win by buying winners, they win by avoiding losers, the bums that can’t – or won’t – pay their debts: Orange County, WorldCom, GM, Lehman. Successful bond investors need to do more than just buy-and-hold. They have to buy and think. And watch out for bums.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”