Big Bond Investors Look Beyond Market Size

Pimco and others shift from weighting government bond holdings by amount of debt; move may raise borrowing costs for industrialized nations.

The world’s biggest investors are moving away from allocating money to government bond markets based on their amount of debt, a strategy that has favored the largest borrowers for three decades.

Norway’s $702 billion sovereign-wealth fund and Pacific Investment Management Co. are starting to shift to indexes that favor less-indebted nations with growing gross domestic product, such as Brazil and South Korea. Pimco boosted the proportion of Mexican holdings while trimming the percentage allocated to U.S. issues in its biggest exchange-traded fund. BlackRock Inc., the world’s largest money manager, with $3.8 trillion in assets, has $3 billion tied to a gauge based on credit-worthiness rather than capitalization.

The move away from market-size benchmarks that guide at least $9 trillion in fixed-income investments may raise borrowing costs for industrialized nations and curb those for developing economies. Bonds from the Group of Seven countries underperformed the global government debt market last year by the most on record.

“We’re beginning to see enough evidence on the side of GDP indexes and seeing investors finally pulling the trigger toward making the reallocation,” Saumil Parikh, a money manager and member of the investment committee at Newport Beach, California-based Pimco, which runs the world’s biggest bond fund, said in a telephone interview Dec. 10. “The tyranny of market-cap indexing is finally now going to go into reverse.”

The three-decade rally in sovereign securities has depended on steady inflows into the most-indebted nations. Money managers traditionally benchmarked performance against indexes weighted to markets with the most debt, giving greater emphasis to the U.S., Japan and Italy at the expense of nations that borrowed less even if they were growing faster.

Global borrowings outstanding totaled $25.7 trillion as of Jan. 15, with 83 percent in G-7 countries and 13 percent in emerging-market nations, Bank of America Corp. data show.

The ratios of debt to GDP climbed to records of 93.6 percent for the U.S. and 205.5 percent for Japan, from 62 percent and 170 percent in 2007. The U.S. is poised to overtake Japan this year as the nation with the most amount of debt due, with maturities rising to $2.9 trillion from $2.6 trillion.


Bigger Gains

Indexes based on the size of economies are doing better than those using the amount of debt outstanding.

A Barclays Plc measure focusing on GDP returned 6.9 percent last year, versus 4.3 percent for the bank’s benchmark for global bonds using market capitalization, the biggest difference in data going back to 2001. Pimco’s Global Advantage Bond Index, which is based on GDP instead of debt outstanding, gained more than twice the Barclays standard gauge in 2012.

Debt of G-7 countries returned 3.8 percent last year, 0.8 percentage point less than for all sovereigns, the widest gap on record, according to Bank of America Merrill Lynch index data.

The Barclays Global Aggregate Bond Index, the most-used market-capitalization benchmark for government and non- government global bonds, is weighted 36 percent to the U.S., followed by Japan at 18 percent. Japan has the highest allocation in the Barclays Global Treasury Bond Index, which measures sovereign debt, at 29 percent, followed by the U.S. at 27 percent. Mexico makes up about 0.6 percent of the gauges.

In 2009 the London-based bank introduced the Barclays Global Aggregate GDP Weighted Index, which is weighted 31 percent to the U.S., 12 percent to Japan and 3.7 percent to Mexico.

While the U.S. and Japan lead allocations in both, countries such as Mexico, South Korea and Australia have bigger shares in the economy-based measures than they do in the standard gauges. Australia’s debt totals 26.7 percent of its GDP, while it’s 33.6 percent for South Korea, and 35.4 percent for Mexico.

Allocations of bond funds based on GDP are still a small part of the total. Pimco has about $18 billion of its $1.9 trillion in assets tied to its GDP measures. Fidelity Investments attracted $193 million since May to track an economy-weighted benchmark. The Boston-based firm has $1.6 trillion under management.

Investors can’t always get bonds of countries with the highest growth rates, such as China and India, amid restrictions on foreign ownership, according to Chris Redmond, head of global bond-manager research at consulting firm Towers Watson.


Transition Phase

About 25 percent of Towers Watson’s institutional clients are moving away from market-based weightings in some part of their holdings, London-based Redmond said in a telephone interview Dec. 12.

Over time, investors will realize the benefits of the new approach, according to Chris Orndorff, a senior money manager for Pasadena, California-based Western Asset Management Co.

“The industry is in a transition phase currently, but clearly moving away from market-cap weighted benchmarks,” Orndorff, whose firm oversees about $460 billion in assets, said in an e-mail Dec. 20. “The full evolution may take a decade to be realized.”

So far, the U.S., Europe, Japan or the U.K. haven’t been hurt by the changing allocations. They all have reserve currencies and central banks that have bought more than $5.3 trillion in bonds since 2008 to drive down interest rates and support their economies, according to Bianco Research LLC.

Yields on 10-year Treasury notes reached a record low in July of 1.379 percent, those on Japan’s benchmark bonds were a nine-year low of 0.685 percent in December and U.K. gilts dropped to a record low of 1.41 percent in July, according to data compiled by Bloomberg.

U.S. 10-year yields were at 1.87 percent as of 6:49 a.m. in New York, from 1.84 percent at the end of last week. They reached 1.97 percent on Jan. 4, the highest level since April. Japan’s five-year rate touched 0.14 percent today, the least since the government started selling the debt in 2000. Ten-year gilt yields were little changed at 2.05 percent.

Returns have started to decline with yields so low. Treasuries are down 0.37 percent this month after gaining 2.2 percent last year, below an average of 3.8 percent in the prior three years. Bunds lost 1.4 percent in January. Bonds measured by the Bank of America Merrill Lynch Global Broad Market Index dropped 0.17 percent this month after returning an average of 5.3 percent over the past four years.


Sales Soar

Sales of U.S. corporate and sovereign issues reached $1.1 trillion in 2012, up from $962.8 billion the year before. GDP growth is expected to slow to 2 percent in 2013 from 2.3 percent last year, according to the median estimate of economists surveyed by Bloomberg. Japan’s economic growth is expected to slow to 0.7 percent in 2013 from 2 percent in 2012, a separate survey shows.

By contrast, Mexico sold 209.4 billion Mexican pesos ($16.5 billion) of government and non-government bonds last year, almost 3 percent less than in 2011. The country’s economy probably grew 3.8 percent in 2012, Bloomberg data show.

Movement away from capitalization-based bond benchmarks may cause higher borrowing costs for countries with elevated debt to GDP over the next few years, Jeffrey Frankel, a professor at Harvard University’s Kennedy School of Government, said in a telephone interview Jan. 2.

“If a lot of investors move in that direction, it will increase the premium that high-debt countries are forced to pay,” said Frankel, who sits on advisory panels for the Federal Reserve Banks of Boston and New York.

Norway’s Government Pension Fund Global, the world’s largest sovereign-wealth fund, started weighting its euro government bond holdings in 2011 using GDP, and in July implemented a new benchmark for all of its sovereign-debt holdings.

Bill Gross, Pimco’s founder and co-chief investment officer, received a patent last year for the methodology behind a global index developed in 2009 that weights countries by the size of their economy rather than indebtedness. The company developed the gauge to reflect its outlook for a prolonged period of subdued returns in developed nations.

Pimco’s Total Return ETF has gained 12.3 percent since it started trading March 1, 9 percentage points more than the Barclays U.S. Aggregate Bond Index.

Even as it increased Mexican holdings and reduced the share of Treasuries, the fund’s dollar amount of U.S. debt increased. The ETF follows a similar strategy to the $285 billion Pimco Total Return Fund, the world’s biggest bond fund.

BlackRock’s Sovereign Risk Index, which was created in June 2011, evaluates countries based on their likelihood of default, devaluation or above-trend inflation, Thomas Christiansen, a strategist at the BlackRock Investment Institute in London, said in a telephone interview Dec. 13. The measure takes into account willingness to repay loans and the term structure of the debt, he said.

The New York-based firm uses the index to reduce exposure to countries most in danger of default, such as Greece, Portugal and Egypt, rather than as a proxy for how to build and weight a fund, according to Christiansen.

“It’s gaining a lot of traction,” Christiansen said. “We realized market-cap weightings essentially reward failures. Hopefully the longer-term implications are that some of these countries become more fiscally responsible.”


Bloomberg News

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