The Big Bad Bond Indexing Boondoggle

May 09, 2005

S&P’s untimely downgrade of GM and Ford credit leaves bond indexers in a huge fix: Choosing between massive turnover and major benchmarking risk.

You don't read much about bond indexing in the press, and for good reason: There's not too much to say.  The industry is totally dominated by Lehman Brothers, turnover in core indexes is low, and the low risk nature of bond investing makes the whole business a bit … dull.  And that's coming from an indexing geek.

But the usually staid world of bond indexing is about to get funky … real funky. 

Standard and Poor's (S&P) recent downgrade of Ford and GM debt to junk status - combined with a major change in the way Lehman Brothers creates it indexes - has created a perfect storm of indexing turnover that will challenge the talents of even the savviest bond index fund managers.

Here's the situation.

The biggest decision you can make in bond indexing is whether something is "investment grade" or "junk."  At Lehman Brothers, that decision is currently based on the more conservative evaluation of two bond rating agencies: S&P and Moody's Investors Service.  If either agency cuts a company's credit rating to junk, that company is kicked out of Lehman's investment grade indexes.

Moody's currently rates both GM and Ford debt as "investment grade."  But S&P's downgrade means that both company's bonds will be kicked out of Lehman's investment grade indexes at the end of this month.

That's big news, because GM and Ford are two of the largest issuers of credit in the United States. Taken together, GM and Ford make up nearly 4 percent of Lehman's U.S. Aggregate Corporate Index, a widely followed index of corporate investment grade credit, and nearly 1 percent of the U.S. Aggregate Index, the most widely followed bond index, which combines both corporate and government-backed investment grade debt.

All told, there's more than $4.3 trillion benchmarked to Lehman's family of bond indexes, with much of that tied to the two indexes mentioned above.  So when Ford and GM are booted out of those indexes at the end of this month, a lot of index funds will be looking to sell. 

But wait, it gets a lot more interesting.

Back in January, Lehman announced a major change to their benchmarking policy: Beginning July 1, the company will start taking into account the opinion of a third ratings agency, Fitch Ratings Service, when deciding if a bond is investment grade or junk.  Under the new system, Lehman will use the middle of the three ratings to place each company in the appropriate index.

You see what's coming, don't you? 

Currently, both Fitch and Moody's rate Ford and GM credit as "investment grade."  As a result, unless one of those two agencies changes their ratings before July 1, Ford and GM credit will re-enter Lehman's investment grade indexes on that date.  And index funds will have to re-buy all the same credit they dumped just one month earlier.

Of course, there's a chance that either Fitch or Moody's will cut their ratings on the automakers to junk before the July 1 deadline - making the above point moot.

But there's also a chance that they will downgrade the credit after July 1.  If that happens, the bonds will be kicked out of the indexes all over again. In, out, in … it's enough to make your head spin.

Lehman Brothers acknowledged that this situation is possible.

What's An Indexer To Do?

The good folks running America's bond index funds are faced with an almost impossible choice.  Bonds representing between one- and four-percent of their benchmarks could exit, enter, and exit those indexes … in the span of a few weeks. 

With literally trillions of dollars tied to these indexes, managers must choose between massive turnover and massive benchmarking risk. Do they hold the bonds from May 31-July 1 and suffer dramatic benchmark risk when these bonds are absent from the index? (Risk amplified by the fact that these bonds are sure to trade dramatically as they change from "investment grade" to "junk.") Or do they follow the index exactly and incur enormous transaction costs - a certain drag on performance.

Vanguard, one of the largest bond indexers, declined to comment on their specific trading strategy. They did say, however, "We are taking the necessary steps to help ensure that our bond index funds continue to parallel their target benchmarks."

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