Traditional bond indexes aren’t what they used to be. In Europe, the risk/reward profile of major investment grade fixed income indexes has broken down since the financial crisis – which led to coordinated policy intervention, increased government debt issuance, downgrades of sovereign bonds and, more recently, negative yields on certain high quality government bonds. These benchmarks now have higher interest rate risk, lower yield and diminished average credit quality than before the crisis.
In our view, these changes underscore the advantages of active bond management. Unlike index funds, which are fully exposed to the concentrated risks now embedded in indexes, active strategies can seek to mitigate concentrated or poorly compensated risks and identify pockets of value across the broad bond markets. In short, an active approach can offer investors exposure to the benefits of bonds while potentially reducing risk and ultimately pursuing higher risk-adjusted returns.
The active-versus-passive debate is an old one, of course, with reasoned arguments on both sides. But when it comes to fixed income, it’s critical to focus on the key role that bonds typically play in portfolios. Investors usually rely on bonds to damp overall portfolio volatility and generate high-quality income. Indeed, the potential for equity diversification stems from a combination of duration and yield in a bond portfolio. Yet, in our view, traditional European bond indexes have evolved in ways that lessen their effectiveness in delivering on this important role in a portfolio.
EUROPEAN BOND INDEXES HAVE BECOME LESS REPRESENTATIVE OF THE BROAD MARKET
The evolution of bond markets in Europe and elsewhere has vastly enlarged the investment opportunity set available to investors. Expansion in the types of instruments and underlying collateral, along with a broader array of issuers of varying credit quality, has enhanced diversification and potential for greater risk-adjusted returns.
Traditional bond indexes have failed to keep pace with these developments in Europe’s bond market. Leading fixed income indexes – and the funds that mimic them – fall well short of their claims to represent the “broad” or “aggregate” market, in our view.
The Citi Euro Broad Investment Grade (EuroBIG) Index, for example, included 3,200 issues totaling €9.4 trillion in market value as of 29 February 2016. Yet the EuroBIG represents less than half the €20 trillion European bond market and a mere 10% of the €90 trillion global bond market.
Nor have traditional indexes kept up with the growing breadth of the European bond market (see Figure 1). The Barclays Euro Aggregate Bond Index and other leading benchmarks exclude key sectors – including inflation-linked, floating-rate and high yield bonds – that have typically outperformed during periods of rising rates. These are securities that we believe can help improve the risk/reward profile of a bond portfolio – at least when actively managed in a carefully monitored, risk-focused manner.
RISK EXPOSURE IS MORE CONCENTRATED TODAY
One attraction to an index is the consistency in the methodology used to construct it. Like most equity indexes, many bond benchmarks are market-capitalization weighted. This approach has its merits, but there also are significant drawbacks. Chief among them: The more debt an issuer floats, the bigger its proportion in the index. As a result, bond indexes tend to expose investors to the most indebted issuers.
Government debt has surged in Europe and other developed countries since the financial crisis, escalating the concentration of sovereign risk in bond indexes
(see Figure 2).
Plummeting yields also have contributed to deterioration in crucial risk/reward measures. As Figure 3 shows, duration in the Euro Aggregate rose from 5.3 years at the end of 2007 to 6.5 years in February 2016. Yield to maturity fell from 4.6% to 0.5%, while the critical measure of yield-per-unit-of-duration tumbled from 0.9 to 0.1 over the period. Bottom line: In our view, using a bond index fund today exposes portfolios to greater interest rate risk without commensurate compensation in the form of yield.
Lastly, increased issuance was followed by downgrades in the creditworthiness of a number of large eurozone sovereign issuers, notably France, Italy and Spain. This resulted in a march downward in average credit quality in the EuroBIG
(see Figure 4).
LOOKING BEYOND EUROPEAN INVESTMENT GRADE INDEXES
Armed with this information, investors should determine the best approach for gaining bond exposure today. Two questions arise: Is a European bond index a good way to construct a bond portfolio? And how does the current risk profile of a benchmark affect the choice between indexing or active management?
To the first question, we would argue there are better ways to gain bond exposure. For example, expanding to a global opportunity set with an index like the Barclays Global Aggregate Bond Index is a straightforward way to potentially improve the risk-adjusted return potential of a bond portfolio. The inclusion of less-correlated bonds from a more diverse array of countries may reduce risk without a meaningful effect on performance. Over the last 10 years, for instance, the largest drawdown of the Euro Agg has been 60% deeper than the largest drawdown of the Global Aggregate, demonstrating the stability that can come through diversification.
Investors can also look to a different breed of index. Smart beta strategies employ benchmarks that reflect the broader fixed income opportunity set and use more forward-looking methods to weight bonds in the index. For example, a smart beta index might use GDP-weighting to determine index allocations instead of the traditional market-capitalization-weighting approach tied to past debt issuance.
Next, is passive investing the right approach in today’s marketplace? In our view, what investors may gain via lower fees in an index fund is more than sacrificed by the lack of risk management. By design, index funds have no mechanism to actively manage risks inherent in the index – and as we have discussed, risks have grown more concentrated. Lacking active risk management, index investors are simply along for the ride, fully exposed to all of the changes to the index – which, in the EuroBIG case, includes a 20% increase in duration, a 90% reduction in yield, and a two-notch downgrade in average credit quality from AA+ to AA- since the end of 2007 through February. And now, to make matters even worse, index investors are compelled to buy bonds with negative yields.
Investors could be better served by looking beyond conventional index funds to improve the risk/reward profile of their bond portfolio. Active management strategies – benchmarked but not beholden to an index – can seek to mitigate concentrated or poorly compensated risks while identifying pockets of value across numerous bond markets. Also, absolute-return-oriented bond strategies can offer investors the benefits of core bonds while potentially mitigating risk and ultimately earning higher risk-adjusted returns.
In our view, traditional European investment grade benchmarks have atrophied and no longer serve well as the basis for an index fund. We believe investors would be wise to strengthen their bond allocations through greater geographic diversification and active management that seeks the benefits of bonds while retaining a focus on mitigating risk and generating higher returns.