Time To Rethink Bond Indexes?
Debt in industrial countries is reaching levels previously unseen outside of wartime. While the debt problems in Greece are the most immediately newsworthy, the phenomenon is present across mature economies. According to the International Monetary Fund, public debt in the industrial world is projected to grow to almost 120 percent of gross domestic product (GDP) by 2015, up from 78 percent in 2007 (Figure 1). This contrasts with the situation in emerging markets, where public debt is expected to decline during the next five years to 33 percent of GDP.
Rising debt levels in industrial countries raise fundamental questions about the construction methodology of traditional bond indexes. Traditional indexes are market-capitalization weighted. There are several conceptual reasons why market-cap-weighted indexes may face a systemic performance drag:
- Highly Indebted Issuer Bias: A market-capitalization index gives the highest weighting to issuers with the greatest amount of outstanding debt. This carries the risk of large weights to entities that may be issuing too many liabilities and undermining their creditworthiness.
- “Buy High, Sell Low” Bias: Market-capitalization indexes increase the weight of instruments that have recently gone up in price, and reduce the weight of instruments that have recently decreased in price. A market-cap-weighted index therefore may give an excess weight to bonds that are at the top of a rally and may be poised for a decline, while giving low weight to bonds that have just declined and may be poised to rally.
- Backward-Looking Bias: A market-capitalization index maps outstanding stocks of debt, which are principally a reflection of historical issuance patterns. Therefore, such an index is unlikely to capture new segments of the capital markets that are experiencing rapid development and therefore positioned to attract growing investment flows in the years ahead.
These drawbacks provide a rationale for exploring alternatives to market capitalization, particularly during a period where concerns about sovereign creditworthiness are in focus.
GDP Weighting: The Theory
An alternative to market-cap weighting is to weight country exposures in global bond indexes by GDP instead of market capitalization.
The GDP-weighting approach helps address the shortcomings of market-cap weighting described above. In contrast to market-cap weighting, GDP weighting does not reward countries with high levels of debt issuance: Countries with higher debt-to-GDP levels generally have a lower representation in a GDP-weighted index versus a market-cap-weighted index. This is because a GDP-based index is income weighted rather than debt weighted. Therefore, the constituents of a representative GDP-weighted government bond index have a weighted average public debt ratio of 79 percent of GDP versus 122 percent of GDP for a representative market-capitalization-weighted government bond index. The market-capitalization index has 31 percent weight to highly indebted countries (debt-to-GDP greater than 120 percent) versus just 1 percent weight in countries with low debt burdens (debt-to-GDP less than 40 percent). In contrast, the GDP-weighted alternative has just 9 percent weight to high-debt countries and 15 percent weight to low-debt countries (Figure 2).
The departure from market-cap weighting avoids the “buy high, sell low” problem intrinsic to that system. Moreover, the GDP-based system can reweight exposures over the economic cycle in a way that enhances index portfolio performance. This is because stronger economic growth tends to reduce the price of bonds, as inflationary pressures build and real interest rates rise. In a GDP-weighted index, therefore, a country’s GDP-determined weight would tend to peak at the same time that the bond market is positioned to rally, and a country’s weight would tend to reach a minimum at the point where the market is positioned to sell off (Figure 3).
Finally, a GDP-weighted approach can help embed a forward-looking orientation in a bond index. Capital market development tends to lag GDP growth in the early stages of economic development, but then markets develop rapidly as countries enter the middle-income strata, which is where large portions of the global economy currently are. Thus by avoiding the capitalization-weighted emphasis on historical issuance patterns, a GDP-weighting approach can provide a better reflection of where capital markets and investor portfolios will be in upcoming years.