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AMERICA'S UNIMAGINABLY MASSIVE BUDGET DEFICITS are hastening the day when it could lose its gilt-edged triple-A credit rating, one of the top credit-rating agencies warned Monday.
But, not to worry. Based on the way most bond money is invested these days, the deeper the U.S. government sinks into debt, the more Treasury notes and bonds fixed-income portfolio managers will have to buy.
That is the necessary, simple-minded consequence of index investing as it's applied to bonds. The bigger the issuer of bonds, the bigger weight its weight in the indexes. So, the more profligate the borrower, the more of its debt the bond index funds have to buy.
Size, and only size, matters when it comes to decisions about capitalization-weighted indexes. In equities, that means allocating the most dollars to the biggest stocks. So, Standard & Poor's 500 funds have to own ExxonMobil (XOM) and Microsoft (MSFT) as their biggest holdings. But coming up fast is Apple (AAPL), which now is the No. 3 holding, passing by Johnson & Johnson (JNJ) and Procter & Gamble (PG.)
Apple's ascendance in the S&P 500 is the result of the more than doubling of its stock price to past 225 as the world clamors for iPhones, iPods, MacBooks and soon, iPads.
In bond land, the same principles have been adopted; the biggest bond issuers get the most weight. But how does that come about? By borrowing the most.
Ultimately, that can lead to the worst credits being the biggest components of the bond indexes. Bigger isn't necessarily better in this case.
Rob Arnott, who heads Research Affiliates, a major consultant to institutional investors, is among the leading critics of simple-minded, cap-weighted indexing. So, I naturally rang him up to discuss the implications of bond indexers' having to buy more of the securities of the most highly indebted, and thus riskiest, issuers.
Arnott pointed to the most egregious anomalies that resulted from this mechanistic approach. Early last decade, Argentina came to dominate the index for emerging-market debt by running up huge deficits. As Arnott recalls, Mohammed El-Erian, now the co-chief executive at Pimco and then the bond shop's emerging markets' head, declined to own Argentine debt for the very same reason it was the biggest component in the index -- it was so deeply in hock. And as it turned out, Argentina defaulted. El-Erian's avoidance of Argentina resulted in a huge winner for Pimco's bond portfolios.
In the U.S., Arnott recalls that U.S. bond index investors had to load up on General Motors bonds when the automaker's indebtedness made it the biggest component in the corporate-bond portion of the indexes; so, investors in the investment-grade indexes had to own GM bonds whether they wanted to or not. Then, when GM got downgraded to junk, it got kicked out of the investment-grade indexes and became the biggest part of the high-yield bond indexes. So, high-yield index funds had to be saddled with GM bonds until the automaker's bankruptcy last year, at which point they had to get rid of the General's bonds—just before they surged in value as GM's fortunes turned around.
And so it is with U.S. government obligations, which have come to dominate the Barclays Aggregate index, the fixed-income analog for the S&P 500. Based on the $11 billion iShares Barclays Aggregate Bond Fund (AGG), the exchange-traded fund that tracks that index, Treasuries comprise 28% of the index. Fannie Mae (FNM) and Freddie Mac (FRE) mortgage-backed and direct securities combined to equal 28%. U.S. agency securities equal 8% while Ginnie Maes account for 6%. Added together, the various government entities comprise 70% of the taxable bond market.
That still understates the true extent of U.S. indebtedness. Were it not for "Enron accounting," Arnott says the U.S. would be worse than Greece.
At year-end, publicly traded U.S. debt equaled 45% debt. But if you count intra-governmental debt (the Social Security, Medicare, Highway trust funds, to which the federal government issues IOUs), that ratio is up to 88%. Add in the government-supported enterprises such as Fannie and Freddie, and we're up to 124% of GDP. Remember, on Christmas Eve, the $200 billion ceiling on federal backing of GSEs' debt was lifted, so they're now effectively full faith and credit obligations of the U.S. government.
Add in unfunded Social Security and Medicare liabilities, Arnott puts the debt-to-GDP ratio at 428%. He says he doesn't worry about that. "What society can't afford won't get paid." Those "entitlements" likely will be limited to those "who don't have a dime in the bank," that is, the indigent elderly.
Yet, America's massive debt burden results in its weighting on bond indexes to climb inexorably, forcing the indexers to buy more. Billions of fixed-income portfolios are programmed to do just that. Among avenues for individual investors, the Vanguard Total Bond Index Fund has some $68 billion while the analogous Fidelity Total Bond Fund has about $11 billion. On the institutional side, hundreds of billions either track the index overtly or ape it.
When or if this obvious flaw in fixed-income indexing gets fixed is anybody's guess. In the meantime, the worst debtor ranks first.
Comments: randall.forsyth@barrons.com
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