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Why It’s Time to Rethink Traditional Government Bond Indices

Andrew Balls, managing director and head of European portfolio management at PIMCO explains why traditional benchmarking strategies are failing to accurately represent a rapidly changing world characterised by wider distribution and fatter tails, particularly within the eurozone.

As we look out over the next few years, we face a secular outlook of a flatter distribution of possible outcomes and fatter tails, which is an investment professional’s way of saying that there is a very wide range of possible outcomes rather than a single, dominant baseline scenario. This is true at the global level as the world economy recovers following the huge shocks of the past few years. And nowhere is this more clearly illustrated than in the eurozone, where the single currency area faces acute economic, institutional, coordination and political challenges.

There are a range of possible outcomes for the eurozone. At one extreme is successful fiscal adjustment, the creation of a deeper fiscal union and the creation of a European Monetary Fund – built on the foundations of the SPV – to ensure that this never happens again. At the other extreme it could involve exit from the eurozone by one or more countries, and it may not be just the eurozone’s weakest members that will have to leave. It is possible that Germany may one day see the benefits of a return to the deutschemark outweighing that of European solidarity. The unthinkable has become thinkable.

In the middle, it could involve the preservation of the existing eurozone, albeit as a weaker entity and without government interventions being able to prevent one or more countries defaulting on their debt owing to overwhelming economic and political realities. Even with the full engagement of the ECB’s balance sheet, the challenges of achieving growth and keeping investors engaged would remain.

The range of outcomes is wide, but it is skewed toward wider spreads and it is certainly very hard to see European sovereign spreads returning to their old normal levels other than in the most optimistic scenarios of successful outcomes on fiscal policy, overall coordination and political support. Greece’s downgrade to non–investment grade status emphasises the extent of the challenge, with Greece now dropping out of the indices of passive investors. The demand curve has shifted inward and given the extent to which other European sovereigns have traded relatively more as credit and less as interest rate risk, the impact may be more widely felt and prolonged.

There is a strong case for watching from the sidelines, to wait and see how policy interventions develop and the extent to which countries are able to deliver on their fiscal contraction without undermining growth. But not all investors are afforded the luxury of watching from the sidelines. Some investors, namely those with specific liability-matching requirements, strict investment guidelines, or for regulatory or asset allocation reasons, are required to have European fixed income beta. Equally, there are institutional investors who may not be required to hold European beta but who will want to capitalise on global opportunities, particularly in emerging markets which look compelling given their better initial conditions and lower debt ratios. In either case, the selection of beta is critical. In such instances, the case for alternative and “smarter” benchmarks that avoid the bias of traditional indices toward high-debt issuers and embed more favourable performance characteristics in their fixed income benchmarks, is strong.

Traditional bond indices, by virtue of their market capitalisation weighting methodology, have an inherent structural bias to overweight countries with high levels of debt. Larger issuance is correlated with larger market capitalisation, which means larger weight in the index. Obviously, this may not be an ideal approach for a bond investor that is focused on the creditworthiness of issuers and their ability to service debt in the future.

And as concerns about sovereign creditworthiness become increasingly critical to asset allocation, there is greater urgency for an alternative to traditional approaches. Instead of giving the highest weights to the countries with the most debt, innovative indices that give the highest weights to countries with the highest income based on gross domestic product (GDP) rather than outstanding stocks of debt, has an obvious appeal in the current economic environment.

In contrast, a GDP-weighted approach to government bond indexing ensures higher allocation to low-debt countries. A GDP-weighted approach bases allocation on national income (GDP), which embodies the capacity to repay debt. The income-orientated approach produces a government bond beta with an emphasis on countries with lower leverage, or lower levels of debt relative to their ability to service the debt, as illustrated in Figure 1.

GDP-weighting also produces a composition that is more forward-looking, providing a better reflection of where capital markets and investor portfolios will be in coming years. Traditional patterns of global indebtedness are being reversed, as industrialised countries expand government debt issuance at an accelerated pace while many emerging economies have become large-scale creditors to the rest of the world. Once regarded as exotic, opportunities in the emerging markets are increasingly becoming an essential element of core fixed income portfolios. Market capitalisation-weighted indices fail to capture these changes because they are inherently backward-looking, reflecting past patterns of capital market development.

Finally, GDP-weighting benefits from counter-cyclical rebalancing features. Another well-known disadvantage of market capitalisation-weighted indices is that they assign progressively greater weight to securities as they go up in price, exactly the opposite of the investment maxim to “buy low, sell high.” GDP-weighted indices not only avoids this pitfall of market-capitalisation weighting, but also has the potential to benefit from counter-cyclical rebalancing, since bond prices tend to move inversely to GDP growth over the business cycle, with bond prices rising as economic growth slows, and falling as economic growth accelerates. A GDP-weighted index that increases the relative weight of countries in the expansion phase of the business cycle (when bond prices are low) and reduces the relative weight of countries in the contraction phase (when bond prices are high) helps embed a “buy low, sell high” bias, as illustrated in Figure 2.

As we head towards an economic environment characterised by lower growth in the developed economies, higher growth in the emerging economies and greater government intervention and regulation overall,  the use of historical models and econometric forecasting based on the experience of the past several decades may not only be useless, but counterproductive. It may be high time we reassess how to gain exposure to government bonds.

Company Profile

With more than US$149 billion (€122 billion, £100 billion) of assets managed or serviced out of Europe and more than US$1 trillion worldwide (€913 billion, £747 billion)¹ , PIMCO is one of the world's leading investment management companies.
 
PIMCO, founded in 1971, is a global investment management firm serving a full range of institutional investors worldwide. Once known primarily as a bond manager, PIMCO today provides an array of investment solutions across numerous asset classes. Since its founding, PIMCO’s mission has been to preserve and protect the assets of its clients, and to provide them with consistent risk-adjusted returns. PIMCO has offices in North America, Europe, Asia and Australia, and is owned by Allianz Global Investors, a subsidiary of the Munich-based Allianz Group, a leading global insurance company.

Over the last 18 months, PIMCO has won a number of prestigious awards including Fixed Income Provider of the Year at the Global Pensions Awards in 2008 and 2009, and US Asset Manager of the Year at the Global Investor Awards 2009. At the European Pensions Award 2009, PIMCO was named LDI Manager of the Year, Commodities Manager of the Year and was also awarded a “Highly Commended” in the category Fixed Income Manager of the Year. In 2007, Co-CIO and founder Bill Gross and his team were awarded the Fixed Income Manager of the Year award by Morningstar for the third time in a decade, the first asset manager to achieve this. In 2010, Morningstar named Bill Gross and his team Fixed Income Manager of the Decade.

¹ As at 30 June 2010