As we have previously noted, based on our assessment of the underlying return generating processes as well as historical correlations of returns, there are at least six different asset classes within the overall debt market. These include (1) real return bonds; (2) domestic investment grade bonds; (3) domestic high yield bonds; (4) bank loans; (5) foreign currency bonds; and (6) emerging markets bonds.

Bond Indexing

Let's now move on to a look at index investing in the debt markets. We'll begin with a discussion of the issues related to the construction of bond indexes. As we have already noted, just the data management challenge involved is enormous, given the size and fragmented nature of the market. However, given the ever-growing number of bond indexes available, it is a challenge that more than a few firms are ready to meet. However, bond indexing also raises some even more fundamental issues.

In general, financial market indexes are constructed with one or two goals in mind. The first is to measure the amount of economic value being created (or destroyed) in a given asset class. The second is to provide a benchmark for measuring the performance of active investment managers. With respect to both goals, one question is how many bonds must be included in an index to provide an accurate basis for measuring either asset class value creation or the performance of active managers. The relatively high level of systematic to issuer-specific risk (at least in the investment grade segment of the market) already mentioned in this article suggests that relatively few bonds need to be included in an index to estimate asset class value changes with reasonable accuracy. Moreover, limiting the number of bonds included in the index to large, liquid issues (which, theoretically, would be easy to replicate in an index fund) also makes any performance comparisons more realistic.

In practice, this is a major point of distinction between the producers of bond indexes. For example, in its InvesTop Index (which covers investment grade U.S. corporate bonds), Goldman Sachs includes just 100 bonds, while the Dow Jones Corporate Bond Index includes just 96. At the other extreme, the Lehman Brothers Aggregate Bond Index, which tracks the performance of investment grade U.S. bonds (including corporates, governments, agencies, mortgages, and asset backed bonds) includes over 5,000 bonds (but still captures well under half the total capitalization of the U.S. bond market). By definition, including this many bonds in an index forces any fund trying to track it to use a sampling strategy rather than outright replication. However, doing this almost certainly results in higher tracking error (i.e., deviation of fund performance from the index it is trying to track).

A closely related issue in an index that contains many bonds is the accuracy of the prices that are used to calculate index returns. With a smaller number of highly liquid issues, there is higher confidence in the prices used, and thus in the index returns and in any conclusions that are drawn from them.

Another important issue is whether the bonds included in an index should be weighted by market capitalization, or by some other scheme (e.g., equal weighting, or, for global indexes, by the relative size of each country's bond market or gross domestic product). Market capitalization weighting is most commonly used in equity indexes, so it is a good place to start. For example, consider the case of market with two issuers (A and B) and two bonds. Assume they mature in ten years, and have a 5% coupon and a 5% yield. Their present value is equal to their face value of $1,000, and the index value is equal to $2,000. Now assume that a year later, the yield on company B's bonds rises to 6.0% due to an increase in the perceived riskiness of the issuer. This causes the bond's market value to fall to about $932 dollars, and the value of the index to fall to $1,932. So far, so good -- market capitalization weighting appears to capture the change in economic value that has happened in our small bond market. Now let's further assume that both of our two issuers decide to expand their businesses. However, company A decides to finance this by selling $1,000 worth of stock, while company B issues $1,000 worth of 10 year, 6% coupon bonds (since their coupon is equal to the current yield on B's bonds, their present value is also $1,000). However, because company A now has relatively more equity in its capital structure, it is perceived to be less risky, so the yield on its bonds falls to 4%, and their value rises to $1,074. The net impact of these changes causes the total market capitalization of our little bond market to rise to $3,006.

Meanwhile, let's take a look at what's happened in the equity market. Assume both companies started with revenue of $100, operating expense of $10 (hey, they're profitable businesses!), and interest expense (which is based on the coupon rate) of $50 each. This means they both have cash profits of $40. However, since company B is perceived to be slightly more risky, its cost of equity is 11%, versus only 10% at company A. At the end of the first year, the market value of A is ($40/10%) or $400, and B is ($40/11%) or $364. Our equity index is worth $764. Now let's look at the end of year two. Assume their respective expansions have doubled revenues and costs at both companies. However, because A financed its expansion with equity, its interest expense is still $50. Its profit is therefore $200-$20-$50 = $130. At its 10% cost of equity, this results in a market value of $1,300, or an increase of 225%. Now consider the situation over at company B. Because of its rising debt costs, its profits are lower: $200-$20-$110 = $70. Moreover, because of its rising debt levels, its equity investors perceive it to be riskier, and require a 12% return. The value of its equity is therefore ($70/12%) = $583. Over the year, the market value of its equity increased by 60%. At the end of the year, the overall equity index had increased from $764 to $1,883, or by 147%.

Now let's ask a simple question: what has happened to our bond and equity market indexes? In the equity market, the answer is easy: the company that has created the most value has increased its weight in the index. If I am an investor in a fund that tracks this index, I consider this performance satisfying. If I am an active manager whose performance is measured against the index, I probably consider it a fair benchmark.

However, in the bond market the answer isn't so clear-cut. In this case, the company that is perceived to be riskier now accounts for a greater share of the index. As an investor in a bond index fund, I'm not sure I'm comfortable with this result. On the other hand, as an active manager, I might not complain too much, assuming I had over-weighted company A's bonds over the past year.

Unfortunately, this is not just a theoretical exercise. Consider two examples: since the early 1990s, the sector weights in the Lehman Brothers Aggregate Bond Index have shifted quite dramatically, with Treasury Bonds declining, and mortgage and corporate bonds increasing their shares. As a result the index has become riskier overall. Similarly, the past decade has also seen a dramatic change in the country composition of global bond indexes. The U.S. share has declined (thanks to those current account surpluses in the late 1990s) while the Japanese share has risen as that country issued debt to finance government spending in an attempt to get the economy out of its prolonged deflation. In other words, investors in market cap weighted global bond indexes found their exposure to Japan increasing at the very time that its credit quality was declining, while just the opposite was happening with respect to their exposure to U.S. Treasuries (or, more recently, to their exposure to Canadian and Australian Treasuries).

At this point, somebody will ask whether the same thing didn't happen to the weight of technology stocks in equity indexes during the internet boom. In our opinion, there is an important difference between the two situations. One can make an argument that the high values of internet companies reflected not irrationality (or at least not just irrationality), but genuine uncertainty about the eventual economic impact of the new technologies they were bringing to market. As these uncertainties were resolved, equity values fell (aided no doubt, by a switch in emotional orientation from greed to fear). This is just the opposite of the argument for why Microsoft's market capitalization remained small in its early years -- investors just didn't realize the amount of value its business model eventually would create. In contrast, can anyone claim that Japan's growing weight in market capitalization-weighted indexes reflected investor uncertainty or irrationality?

From our perspective, it seems clear that market capitalization weighting works best in the case of residual claims like equity; when the claims are fixed in nature, market capitalization weighting has some pretty clear drawbacks.
What then, are the alternatives to it? Basically, there are two: equal weighting, and, in the case of international indexes, weighting based on relative shares of world gross domestic product.

As previously noted, both the Goldman Sachs InvestTop Index (which is the basis for the LQD exchange traded fund) and the Dow Jones Corporate Bond Index use equal weighting. The latter offers a further advantage, in that it is constructed as a yield curve, which facilitates the consistent comparison of the risk/reward ratios of corporate versus government bonds. If applied to a broader spectrum of the bond market, it seems to us that this type of indexing approach would do a superior job of measuring changes in economic value creation for different combinations of duration and other types of risk. For this reason, it might be more attractive to bond index investors, and if not always more acceptable to them (because it raises the bar), at least a more accurate basis for evaluating active managers' performance.

Let's now look at how GDP weighting would change international index weights. The following table shows the shares of five key countries, plus the Eurozone, in world GDP (as measured by the IMF), world equity market capitalization (as measured by the Standard and Poor's Citigroup Broad Market Index), world bond market capitalization (as measured by the BIS), and in two major global bond indexes: the MSCI World Sovereign Bond Index and the Lehman Brothers Global Aggregate Index (which includes only investment grade debt.

Pct of GDPPct o

As you can see, there are some significant differences between the six areas' weightings on different criteria. First, by comparing an area's weighting on debt and equity, you can see how the preferred financing approach differs around the world. In broad terms, equity is the preferred vehicle in the Anglosphere, while debt is preferred elsewhere. Second, you can see that the debt market weightings used in the two bond indexes differ from the weights calculated by the BIS. This is because the two indexes leave out important segments of the world's debt markets. To varying degrees, these are covered by other indexes, including tax-advantaged municipal government bonds (in the U.S.), real return bonds, high yield bonds, and emerging markets bonds. You can also see the size of the "Japan problem", which is most significant in the Sovereign Bond Index. Similarly, the relative importance of different bond market segments (e.g., government versus non-government) in different countries is apparent from a comparison of the Sovereign Bond to the Global Aggregate Index. Non-government bonds (including high yield bonds) play a much larger role in the U.S. bond market than they do elsewhere. Finally, you can see the potential impact of a switch to global GDP weighting, which would significantly reduce Japan's weight in a bond index, and increase Australia's and Canada's weights.

Should You Be an Index Investor in Debt Markets?

The problems we have just described raise a logical question: should you be an passive investor in debt markets, or should you take an active approach? Let's look at the arguments on both sides of this issue.

First, we need to clarify what we mean by passive bond investing. Broadly speaking, this can take two forms: either investing in a bond index fund, or managing your own "bond ladder." This involves buying bonds of different durations, and then over time reinvesting the proceeds of maturing bonds into new bonds with long duration. Most often, this is done with high quality municipal (tax advantaged) or federal government bonds, so that the investor can minimize transaction costs and avoid having to actively manage credit quality issues.

Regardless of the passive approach taken, there are good arguments against active bond management. To begin with, we need to distinguish between taking a tilt within a given bond asset class (e.g., giving relatively more weight to corporate bonds than they have in a broad index) and genuine active management skill. In an efficient market, taking a permanent tilt away from a broad index should produce either more return with more risk than the index, or less return with less risk. True active management skill would involve some combination of keeping the same segment weights as the broad index (e.g., in governments, mortgages, corporates and asset-backed securities), but earning higher returns due to superior bond selection within these segments (e.g., due to better understanding of credit or prepayment risk), or, alternatively, tactically changing segment weights.

However, as previously noted, the inescapable fact is that the great majority of investment grade bond returns are due to systematic interest rate risk -- that is, they are due to changes in the level or shape of the government yield curve. Consequently, the potential gains from successful active management are small relative to what the additional active risk taken on can produce in other asset classes. These potential gains look even smaller after taking into account the additional costs (in the form of annual expense charges and front-end sales loads) that are charged by actively managed funds. Moreover, studies have shown that bond fund managers' ability to accurately forecast interest rate changes is not good. This causes a substantial percentage of active managers to underperform (even poorly structured) indexes (see, for example, "The Timing Ability of Fixed Income Mutual Funds" by Chen, Ferson and Peters, and "Evaluating Government Bond Fund Performance with Stochastic Discount Factors" by Ferson, Henry and Kisgen).

Now let's look at the arguments against passive bond investing. The first is the poor quality the underlying market capitalization based indexes tracked by many bond index funds. Second, there are some very well known active bond managers, who have been able to sustain superior performance even as their funds have grown in size. Consider the following table, which compares the five year performance of Vanguard's actively managed investment grade bond funds to the performance of its index funds (which track the Lehman Government/Credit Short, Intermediate, and Long-Term Indexes). We have also included PIMCO's Total Return Fund, one of the best of the large actively managed bond funds, as well as the Vanguard index fund that tracks the broad Lehman Brothers Aggregate Bond Index:

Our final argument against debt market indexing is a practical one: for whatever reason, few, if any index funds exist in some key segments of the debt market, including real return bonds, foreign currency bonds, bank loans, high yield bonds, and emerging markets bonds.

So Where Do We Stand?

Based on our analysis, we have come to the following conclusions:

• We believe that a number of different debt market asset classes should be considered in any asset allocation analysis. These include real return bonds, domestic investment grade bonds, foreign currency bonds, and bank loans. We will incorporate bank loans into our biannual asset allocation review later this year.
  
  
• Assuming an investor finds the underlying credit risk of the wrap provider acceptable, a stable value fund can substitute for an allocation to domestic investment grade bonds.
  
  
• We also believe that the weight of evidence supports a tilt toward intermediate duration bonds within the domestic investment grade and foreign currency bonds' asset classes.
  
  
• We do not believe that an investment in either high yield bonds or emerging markets bonds makes sense for most investors' portfolios. While both asset classes appear attractive in terms of expected returns and standard deviations, the data series upon which these statistics are based are quite short. In addition the distribution of returns for both asset classes is far from normal. In both cases, an investor has a significantly higher than normal chance of realizing large negative returns (a risk that is not captured by standard deviation, but rather by statistical measures of skewness and kurtosis). We recognize that if an investor's objective is to outperform a benchmark over a one year time horizon this may not matter too much (e.g., this would be the case for an investment manager whose performance is evaluated annually by his or her clients). However, for an investor whose time horizon stretches over many years (i.e., an investor whose goal is to achieve the minimum compound annual return needed to fund her long-term liabilities), this elevated level of "extreme event risk" is an important consideration when determining a portfolio's asset allocation. A substantial loss early in the time horizon can materially reduce the probability of achieving the long-term portfolio return target. For this reason, we have not included high yield or emerging markets bonds in our long-term target real return portfolios.
  
  
• On the issue of passive versus active implementation of portfolio allocations to debt asset classes, we recognize that the arguments for active management, particularly of intermediate duration funds, appear to be stronger than they are in the case of equities. Still, it is a very close call, and an active fund's costs are critical. In our model portfolios, we'll be sticking with VBMFX. We also believe that the future introduction of better bond indexes and new products based on these new indexes will weaken the argument for active management (as evidenced by the success of the LQD ETF which tracks the equally weighted Goldman Sachs InvestTop Index). However, given the current absence of such indexes in key segments of the debt market (e.g., foreign currency bonds, bank loans), we will continue to search for and use some high quality actively managed funds in our model portfolios.