Wednesday, 25 January 2012

Bond Misconceptions

The article today on SmartMoney offers a perspective on bonds questioning the efficacy of weighting an index according to debt outstanding suggesting instead that the new Citi RAFI index will provide a better weighting system as it factors in GDP, energy consumption, population and resources.

Now certainly merely investing at the total weight of debt in an index is a dumb way to invest. However a lot of conclusions in the article are far too simplistic. The 4 key factors are all flawed. GDP is a simplistic measure of economic output, population as a proxy for labour ignores demographics (compare Japan’s labour force to that of Bangladesh), resources as a derivative of land mass ignores economically useless land (Russian and Canadian arctic tundra) and energy consumption ignores production; the Saudis use as much energy per capita as the Americans but its basically free and abundant.

There are several key factors beyond these 4 basic filters which really influence global bond markets;

There is a reason why people buy US treasuries beyond the typical solvency arguments. It is because the UST market is the most liquid bond market in the world. We can all see quite clearly the relative attractiveness of a Chilean government bond; debt to GDP is miniscule, strong central bank, lots of natural resources but guess what; there is hardly a market. The Chileans issue government bonds principally to create a market for their banks as they don’t even need the money. So according to the above 4 factors the Chilean bond market would look great. Until you try and actually buy the bonds and blowout the price.

What the article totally ignores is the impact of central banks and currency on global bond markets. Lending to Japan, the US or the UK is not dangerous from a solvency perspective simply because a country borrowing in its own currency can effectively do whatever it wants. There is a reason emerging markets have had more debt crises and are a much smaller proportion of global debt; they like to borrow in dollars. They borrow in dollars but they can’t print dollars so they can go bust. As Pettis explains this causes emerging central banks to hoard dollars (US treasuries) and by implication the US must continue to issue debt to fund the entire system of global trade. 

Further the article severely overestimates the impact of global bond index investors on the market;

“The current system enabled Greece to borrow cheaply money that it cannot and will not ever repay, and yields barely half a percent above Germany's. It means investors pouring money into global or international bond funds are inevitably lending truckloads of money to Japan, for no obvious reason and at minuscule interest rates.”

Greece is in dire straits now because it ran a huge trade deficit with Germany for a decade and needed a way to fund that deficit. Index funds were not the holders of Greek bonds; French and German banks are and that is what moved the market.

Japanese bonds appear a bizarre and awful investment to outsiders because of low yields and a huge debt burden. What people miss is that Japan has been undergoing two decades of deflation so 0.5% return and 100% capital protection looks a safe bet; if you are Japanese. Hence the domestic market supports this environment.

Foreigner indexers clearly do not move the Japanese bond market. If they did yields would be way higher.

My conclusion on bond investing is if you don’t like investing at a dumb index why not just buy a low-cost active managed fund? Putting layers upon layers of filters on an index just makes it more active but still ultimately unresponsive to change.

My conclusion on bond indices by size is that in bonds size is everything. A sovereign debt is not like a company or an individual because the sovereign can change the rules. The bigger you are the more you can bend the rules; the reason for this is that if you are the US treasury you know people have to hold your bonds to finance trade. This is also why nobody cares if Greek bonds collapse but Italian bonds would destroy the Euro. Now the irony is that at first blush this isn’t good for investors who get repressed or burned but on the other hand what could be safer? Sure the government can change the rules but it’s the flexibility to do so which makes these bond markets attractive.

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change.”

-Charles Darwin

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