Inglorious Debtors in Global Bond Indexes?
In his classic little book "Economics in One Lesson", first published in 1946, economist Henry Hazlitt observed that "there is no more persistent and influential faith in the world today than faith in government spending."
Sound familiar? Today's disciples of government spending argue that more stimulus efforts are needed to deliver us from our economic problems. Policymakers around the world (including high priest Bernanke) are acting with conviction. In fact, according to a January 2010 study by Kenneth Rogoff and Carmen Reinhart, for the five countries with the most acute financial crises (Iceland, Ireland, Spain, the United Kingdom, and the United States), average public debt levels are up by approximately 75 percent over the last two years. And, it's a trend that shows no signs of slowing.
ETFocus remains unconverted. Instead, we will play the heretic ... siding with Mr. Hazlitt's doctrine. Yes, government stimulus will intermittently lift the economy (such as the experience in recent quarters). And, yes, a certain amount of government spending is necessary to supply essential public services.
But government stimulus is not a free lunch. Ultimately, it either taxes or borrows from future growth. Offsetting periods will surely follow temporary advances. And, the longer term effects of these policies must be analyzed to understand the big picture. Quoting from Hazlitt, "the art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy". In the same study by Rogoff and Reinhart, the researchers conclude that once a country's public debt purges the 90% threshold, GDP growth typically slows by an average 1% per annum (see chart 2).
Global Bond ETFs -- Losing the Faith? The enormous expansion of sovereign balance sheets in advanced G-20 economies has been alarming to many. Yet, it is a trend that will continue for some time. Why? For the simple reason that the private sector in the Western world faces a long de-leveraging period. Therefore, in an attempt to thwart the collapse in private debt, more frantic efforts by governments at fiscal and monetary easing should be expected.
A recent report confirms this forecast. The McKinsey Global Institute analyzed 45 historic episodes of crisis since 1930 and concluded that a long period of deleveraging nearly always follows a major financial crisis. The study concludes that de-leveraging begins two years after the beginning of the crisis and lasts for 6 to 7 years, reducing the ratio of total national debt to GDP by 25 percent (due to a reduction in private borrowing).
Trends in government debt expansion will be one of the key investment themes that shape portfolio decisions for the next several years. Taken with Hazlitt's observations, these developments have important implications for global bond ETF investors. Consider that most international bond indices track "capitalization-weighted" benchmarks.
This means that countries with the largest issuance of debt have the largest weights in the index. (Laurence B. Siegel of the Ford Foundation calls this the "bums" or "deadbeats" problem). To the extent that more debt is a sign of future distress, these traditional global bond indexes have a structural bias -- overweighting those nations likely to face future debt dislocations or credit downgrades.
Although there are still very few domestically-listed ETFs tracking global bond indices, let's look at one. The iShares International Treasury Bond Fund (Nasdaq: IGOV) tracks the S&P/Citigroup International Treasury Bond Index Ex-US. By far, the largest weight is Japan at 24.5%, a country that has mismanaged its public finances, increasing its public debt threefold since its de-leveraging period began in the early 1990s (see chart 1 ... interestingly, both government debt relative to GDP was approximately 50% in both Japan and the US prior to commencement of their de-leveraging periods). Clearly, this adversely skews the composition of the underlying index.
The Paradox of Fixed Income Indexes. How should investors respond to the cap-weighted index bias? And, are all cap-weighted bond benchmarks, including corporate indexes, inefficient? Not quite. Consider that active bond fund track records are even more dismal than their equity counterparts, chronically underperforming relevant benchmarks. Standard and Poor's bi-annually releases its "Active Fund Scorecard" report and consistently reaches the same conclusion: over both shorter and longer-term time horizons, active bond managers overall fail to deliver added value through security selection. The mid-year 2009 report shows that for the last five years, across all categories except emerging market debt, more than three-fourths of active managers have failed to beat fixed income benchmarks.
Why the grim performance? A few reasons, including the fees of the croupiers and managers. But the most important explanation relates to risk management ... or lack thereof. Bond fund managers tend to deliver decent results in low volatility markets by taking extra risk in higher-yielding securities. Yet, their performance reverses quickly when credit spreads widen and risk premiums surge.
Lord, Make Me A More Prudent Bond Investor. Where does that leave investors? And, importantly, can bond risk be better managed through other methods? Some have suggested equal-weighted, GDP-weighted or fundamental-based bond indexing approaches. Those innovations may be applied to future listings in the ETF space. But, active asset allocation within a disciplined risk management framework already offers a solid approach (and could be used in conjunction with the above indexing innovations).
In fact, all investors should have some type of risk management framework through an active asset mix approach ... taking higher risks when they are well compensated, and reducing risk when they are not. According to global investment management firm, GMO, roughly 95 percent of bond index returns can be explained by yield-curve moves. In other words, individual bond selection is less important as a driver of return. As GMO's venerable leader, Jeremy Grantham, has recently noted, "... asset classes really are more inefficiently priced than individual stocks on average, and therefore offer greater opportunities for adding value and reducing risk."
Given those observations, bond ETFs -- even capweighted ones -- remain excellent tools for managing asset class exposures and risk in bond portfolios. Already, investors can make targeted fixed income decisions based on credit quality, duration or individual countries through ETFs. Other proposed bond ETFs are also encouraging. PowerShares has recently filed with the SEC to launch three sector-specific bond ETFs based on financials, industrials and utilities. While not all of these will be useful innovations, expanding the tool set can only be positive for intelligent global asset allocators. (According to BlackRock, for the year-end 2009, global ETF industry assets exceeded US$1 trillion with 1,947 ETFs and 3,787 listings from 110 providers on 40 exchanges around the world).
Looking Ahead. How else can investors thrive in the current environment? Let's look at some general guidelines for navigating the next several years:
1. Stay "High Quality" in Country Bond ETF Selections. To avoid the "deadbeats" problem, investors need to be selective with their international bond exposures. Broad-based, developed market bond ETFs are unlikely to be successful investments. Our research shows that the "quality" of sovereign fiscal positions drives returns (e.g. attractive growth prospects, solid balance sheets, and appropriate monetary policies). Stay overweight individual countries and regions with these qualities.
2. Favour Emerging Over Western Government Debt. Debt forecasts for developing parts of the world remain much more muted than their Western counterparts. A recent study by the International Monetary Fund shows that bank bailouts and fiscal programs will increase the debt of advanced economies to at least 114 percent of GDP by 2014, more than triple the 35 percent forecasted for the larger developing economies (including China). Indeed, trouble continues to pile up for the most debtaddled developed nations. For example, the UK, at one point in history a bastion of fiscal prudence, has been recently downgraded by S&P, no longer classifying it among the most stable and low risk banking systems. Volatility notwithstanding, a secular currency tailwind is also likely in many of emerging country bonds (see September 2009 ETFocus).
3. Prefer Investment-Grade Corporate Over Sovereign Fixed Income in the Most Indebted Nations. As the private sector de-leverages in the most indebted countries, large corporate debt becomes more attractive than sovereign. Stay overweight, although favour the highest quality issues at this stage in the cycle.
4. Always Manage Bond Risk -- Credit Quality, Duration, Currency and Country Selections. Looking back on the earlier part of 2009, risk was cheap. Credit spreads were hitting historic highs and investors should have been adding to their risk budgets. For the most part, that was not the case ... most investors recoiled and continued to seek safety. Today, risk is back in vogue and expectations have been ratcheted higher. Yet, now is the time to be more defensive. While the macro landscape is continually evolving, a disciplined risk management framework is necessary for bond components, just as it is for all asset types.
Hazlitt's Last Word. In a 1978 follow up edition to Hazlitt's original book, a final chapter was added. In it, Hazlitt observed that governments are "still unceasingly recommending more deficit spending in order to cure or reduce existing unemployment". Indeed, Hazlitt's economic lessons are as relevant today as they were in 1978, or 70 years ago. Politically-motivated deficit spending is not the most prudent macroeconomic policy. Yet, in the context of a colossal ongoing asset deleveraging and debt deflation in the private sector, the government sector in the West is likely just getting warmed up. Investors will need to be vigilant to these risks. While bond ETFs still offer excellent noncorrelated exposures in balanced portfolios, selecting the right asset class exposures will be paramount.