Andrew Canter: Warning to passive investors – bond indices by nature seriously flawed

As passive investing through index trackers becomes increasingly popular, punters are expanding into bonds, previously the preserve of pension funds. Futuregrowth’s CIO Andrew Canter applies his mind to bond indices and explains why they are nearly always deeply and fundamentally flawed. This reality leads to suggestions every now and then that a better measure would be a credit spread index. But Canter explains that in the South African context that would merely raise new problems. – Alec Hogg

This special podcast is brought to you by Futuregrowth and Andrew Canter, the Chief Investment Officer of Future Growth joins us on the line from Cape Town. You’ve been doing a bit of work on bond indices, Andrew, and came to the conclusion that they are nearly always, deeply fundamentally flawed, as you describe it.

Yes, it’s true. The world of investing surrounds around being index cognisant or paying attention to market indices and this comes from the equities world where, you generally have to beat the equity index and it kind of works for equities because, well an equity index is ultimately, (if things go according to plan). The companies grow up, and they become big enough and they become part of the index, so what you get in an equity index for any country or even for the world, is a representative sample of the entire economy. That’s fine. That’s a good kind of proxy, which the professional investor should try to beat.

But different with bonds, isn’t it?

Absolutely, and this is where it is fundamentally different is that it’s not that every company grows up and borrows money in the bond market. What happens is companies grow up, and they want to borrow money in the bond market and the companies that borrow more end up in the index, which is a flawed concept. It’s not the economy. It’s not a fair representation of the economy. It’s actually not a fair representation of anything. I’d be willing to bet that in fact, the big credit indices in the world right before Parmalat went bust, was probably the biggest constituent of one of the European credit indices. Right before Enron went bust, it was probably the largest constituent of any credit index in the U.S. because the people that end up overweight in the indexes are the ones that have borrowed too much money. It’s a deeply flawed thing.

So you, by following the index, in fact are taking a bet of the over geared constituents.

Absolutely, and by the way that’s true of equities as well, so right now one of the big debates of the world is fundamental indexing versus market cap indexing, so if the Apple share price or the Facebook share price goes through the roof and gets to a 100 times PE. It ends up with a huge overweight position in the index and everybody buys it, to the index rate because it’s in the index.

Now, that’s almost as bad but it’s still only one small part of a very large index. Whereas fundamental indexing tries to wait companies and equity indices according to their weight in the economy, so by revenues or by staff composition, or by profits even, so there’s a debate going on there. Broadly speaking, equity indices are safe for bond indices. There is no representatively. People who follow, slavishly follow Bondex will buy what’s in the index, whether they should or they shouldn’t. That’s the core problem.

There’s another danger that you brought in, in the paper that you put together and that relates to the fact that banks might actually not want to take that debt on-board. The covenants with bank debts could be a lot higher than the covenants on the bond debt that people would, in this case be slavishly buying into.

Well that’s right, so what we see in debt capital market, the bond market, is that companies issue bonds to institutional investors because they are generally able to get away with lower covenants, conditions, and securities. They don’t have to feed or pledge a building to you, and they don’t have to agree to a debt to give the Dow or debt to equity ratio. They get away with what are called covenant life bonds, which the banks would never do, and they usually get lower funding rates as well.

What we find, overtime, statistically is when companies fail banks tend to get more of their money back from those companies than bond investors get back. In other words, the banks are senior, if you will, or have security while the bond investors don’t. In short, what’s being done is indices are being sold to investors that would not necessarily be bought by the people selling them. Banks place them but they don’t hold them.

There’s an interesting point about…

It’s like the cigarette manufacturer who is quite happy to sell you cigarettes but refuses to smoke.

There’s an interesting point about that because as markets get more available to everybody, as technology brings them there. Surely, this advantage and it’s a clear advantage that the banks have, in this respect. Compared with other investors in the debt markets – might be eroded.

Yes, there is a bit of that. If you have, professional investors like us and that’s what we do. We run a credit process and in many ways, we compete with the banks in terms of making loans, and we try to get as good terms as they do, for our investors. We don’t do that, generally, with listed bonds because we are not able to control the listed bond market from other people are willing to buy. It’s a least common denominator kind of thing.

Yes, moving back to the bond market itself and these indices – Pension Funds are, traditionally, the biggest holders there but they’re also taking on risks that, (I love your description of it) – if you’re following a passive bond index investing. It is like having a passive stroll in the Kruger Park.

That’s right. Eventually you’ll be eaten by somebody. Some lion is going to take you out if you’re not paying attention, and I think that’s right. Again, what’s being sold on the bond market is stuff that other people may not want, by companies that are maybe borrowing too much. If you do that – if an index is created, a credit index is created, and it is used and it is followed by Pension Funds, by asset consultants, or by asset managers – in the end, when something goes bust you will end up being clobbered because you passively followed the index. When you shouldn’t have bought what was in the index and it’s a very, dangerous thing.

You can get away with that in the equities world because if you go back to what we were saying a minute ago, a share owned by a Pension Fund is the same as a share owned by an individual. It’s the same as a share owned by company management – there’s an alignment of interest. Whereas with debt, there’s all sorts of different instruments, of different levels of seniority and security, and you as an institutional investor or even as a retail investor buying bonds, you tend to get the weakest of the bonds, and that’s what ends up in the index.

You’ve unpacked this really well but how easy is it to get this thought process through to Pension Fund Trustees because, at the end of the day, they are the ones who should be paying attention and making these decisions?

Well, okay, so let’s start with the first principle of bonds, as an asset class. That is instruments to pay a fixed rate, belongs in Pension Funds. It’s a risk stabiliser. It’s a better maxed to long-term liabilities and equities. When the equity market goes down 30 percent, bonds don’t. It’s a good risk stabiliser and belongs in Pension Funds. My core proposition is that the Pension Funds – what they’re looking for is long term, fixed rate debt, or long-term inflationary debt, to match the liabilities. As it so happens, they’ve ended up – because they’ve wanted that, they’ve ended up with a bunch of credit stuff they may or may not have chosen, so that’s the first point.

You have to separate the interest rate decision in your asset liability match from your credit decision, whether you want to take credit risk on borrowers, who may not pay you back. Once you get beyond that, it is possible to take credit risk and do it in an appropriate, sustainable way, and earn higher returns. Rather than earn say, eight or eight-and-a-half percent in the all bond index. You may be able to build a credit portfolio and earn ten-and-a-half or 11 percent. Well that’s great, if you do that in 20 years, at two, two-and-a-half percent gain over 20 years. That’s a huge amount of money but it must be done in a suitable and appropriate way but that requires specialist skills.

I think the problem is that there’s an assumption that bonds are easy and anybody can do it, where you can do it passively, and you can’t. The core proposition – you must think of it like private equity or venture capital or property. You have specialist teams, specialist companies, and specialist people who can actually do credit properly. Banks are good at it. That’s what their core business is. Most institutional investors are not good at it.

Are there any other bond indexes though, here in South Africa that might be worth following or replicating?

Well, so we have the key index we have is the all bond index, and the all bond Index is actually quite a good index, in a sense that it can’t be manipulated. It’s replicable over the long-term yield curve. You can trade it. It’s transparently priced. It has a set of rules of what’s included. It’s actually a good index, but it is basically a government bond index. At this point and in fact the all bond index is entirely government guaranteed between the 15 government bonds in it, and the five Eskom government guaranteed bonds. That kind of suits me.

A sub sort of that is called the GOVI index, which is only the large cap, government issued bonds. I think that is even better. It’s pure. It’s more liquid. It has no credit risk premium in it, so it’s a good foundation. There is no credit index at this point, in South Africa and I think the reason we’re having this discussion is, every now and then the discussion comes up, ‘so shouldn’t we have a credit index’ and my argument is, ‘no, we shouldn’t’. If it’s such a deeply, fundamentally flawed concept – we shouldn’t even bother creating it.

Andrew, in my early days in journalism I used to write about gilts and semi-gilts – gilts being government debts and semi-gilts being that, which was issued by anyone other than the government. Those terms to have gone away, and new terms have replaced them but are there still gilts? If you’re investing in governments stock, is it still gilt-edged?

Well, not literally. In the old days, of course, that phraseology of gilts comes from the old U.K. government bond market, and we’re going back a couple of hundred years, where the certificates, literally, the government bonds had gilt edges. That’s why they were called gilt. Of course, we don’t even issue paper anymore. It’s all book entry and its computer clipped somewhere, when you buy a bond, so we use the terminology now of ‘government guaranteed debt’ or ‘guaranteed or credit risk free bonds’. Then everything else is non-government guaranteed and I suppose semi-gilt. That nomenclature might apply to a company like Sanral, where some of their bonds are government guaranteed (gilt), and some of their bonds are not government guaranteed but it’s still a state owned entity, with implicit state support, so you might call that semi-gilt, like the DVSA, for example.

But it is a sophisticated and a complicated market, and you can’t, as some people do, want to, just buy the Satrix 40 for equities. Just go and buy the bond index and think that you’re home dry.

Well certainly not if it’s credit index and, as I say, right now we don’t have one, so the all bond index – it is a good index. It does work and, by the way, it particularly works for Pension Funds because it’s a long duration. It’s a long-term to maturity index, which more or less kind of gets close to what Pension Funds are trying to do when they buy bonds, so I don’t have any [inaudible: 10:21] with the all bond index, as such. I’d like to exclude any, sort of yield pickup instrument from it, and keep it a pure index that is basically just a government guaranteed governed issued index and we have that if we want to use it. My only concern is that there is a movement, there was a push by some people to create credit indices, and the reasons aren’t clear to me. I think consultants and Pension Funds do want to know if their credit asset manager is beating a fair benchmark, and if your benchmark is the all bond index, so its credit risk free. So you say you beat the all bond index by, say 100 base points per annum. The client doesn’t know whether that’s good or bad. He has no standard risk measure for credit risk. I’m just saying that the cure for that, creating a credit index, is worse than the disease of uncertainty about the veracity of returns.

Andrew Canter is the Chief Investment Officer at Future Growth and this special podcast was brought to you by Future Growth.