Got money in a global bond index fund? You should read this

Global bond index funds carry hidden risks that undermine their role in providing stability and defensiveness to a portfolio. Pendal’s MICHAEL BLAYNEY explains

• Flawed bond indexes weighting based on indebtedness
• Overweight China, Italy
• Find out more about Pendal’s multi-asset funds

A FUNDAMENTAL flaw in global bond indicies undermines their role in providing defensiveness to a portfolio by allocating higher weightings to the most indebted countries.

That’s the view of portfolio manager Michael Blayney, who heads up Pendal’s multi-asset team.

Indexing bond investments appeals to many investors because it offers a low-cost method of incorporating diversified, defensive assets into a portfolio.

But the practice of weighting bond indicies by the market value of outstanding debt can undermine that defensive role.

“At the heart of it, there’s a core problem in bond indicies — the more you borrow, the bigger your weight,” says Blayney.

“That’s different from an equity index, where generally the better your earnings, revenues and growth prospects, the bigger your weight.

“Instead in bonds, it’s how indebted you are that determines your weight.

“Essentially, we are lending more to the people that owe the most money.”

A closer look at the benchmark

The main global bond benchmark — the Bloomberg Global Aggregate Bond Index — tracks the performance of bonds from many different countries.

“It is intended to be an investment-grade index,” says Blayney.

“But it does give you exposure to a number of potentially less-liquid markets that could cause you problems in a crisis.”

Key weightings that could cause concern include a 9 per cent exposure to China, a 5 per cent exposure to emerging markets and a 3 per cent exposure to Italy.

“When you buy a bond index, you’re getting 40 per cent weight to the US with pretty good yields and pretty good credit worthiness.

“But you’re also buying a whole bunch of other markets, a number of which have their own idiosyncratic problems that could bite you in times of crisis,” says Blayney.

“One of the big geopolitical risks of our time is China and Taiwan. In the event of a crisis, is an Australian investor going to be easily able to access and liquidate their Chinese bonds?

“Italy is one of the most indebted countries in the world as a proportion of GDP — it is not necessarily a low risk investment.”

The index also overweights Japan at 12 per cent, which drags down the average yield of the index due to Japan’s very low interest rates, says Blayney.

“The key difference between bonds and equities is asymmetric payoff — with bonds, on a hold to maturity basis, the best you can ever do is get paid back, but the worst you can do is lose all your money.

“In equities, the worst you can do for an individual stock is lose all the money, but you’ve got unlimited upside.”

Your Future, Your Super risks

Many big superannuation funds are carrying unnecessary risk in their fixed income portfolios as a result of the underlying index weightings, argues Blayney.

The federal government’s annual testing regime for super funds benchmarks against pre-set portfolios of passive, low-cost investments that include the Bloomberg Global Aggregate Bond Index.

“This index is specified in the Your Future Your Super regulations as the index that has to be used by super funds,” says Blayney.

Funds that underperform due to straying from the index risk failing the annual assessments.

“And the reality is that any time you take a differentiated approach, you’ll go through periods of underperformance,” says Blayney.

Guarding against the index risk

How can investors guard against these risks?

Blayney says one way is to use sustainable bond funds which tend to screen out China and problematic emerging markets.

Another is to lift home bias.

Australian bond indexes are mostly Commonwealth bonds and state government bonds, which are generally low risk.

“There is a strong case for domestic bias in bonds,” says Blayney.

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About Michael Blayney and Pendal’s Multi-Asset capabilities

Michael Blayney leads Pendal’s multi-asset team. Michael has more than 20 years of investment management and consulting experience. He was previously Head of Investment Strategy at First State Super and head of Diversified Strategies at Perpetual.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

The team — which also includes Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal account manager here