The world's biggest investors are moving away from allocatingmoney to government bond markets based on their amount of debt, astrategy that has favored the largest borrowers for threedecades.

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

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

“We're beginning to see enough evidence on the side of GDPindexes and seeing investors finally pulling the trigger towardmaking the reallocation,” Saumil Parikh, a money manager and memberof the investment committee at Newport Beach, California-basedPimco, which runs the world's biggest bond fund, said in atelephone interview Dec. 10. “The tyranny of market-cap indexing isfinally now going to go into reverse.”

The three-decade rally in sovereign securities has depended onsteady inflows into the most-indebted nations. Money managerstraditionally benchmarked performance against indexes weighted tomarkets with the most debt, giving greater emphasis to the U.S.,Japan and Italy at the expense of nations that borrowed less evenif 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 inemerging-market nations, Bank of America Corp. data show.

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

Bigger Gains

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

A Barclays Plc measure focusing on GDP returned 6.9 percent lastyear, versus 4.3 percent for the bank's benchmark for global bondsusing market capitalization, the biggest difference in data goingback to 2001. Pimco's Global Advantage Bond Index, which is basedon GDP instead of debt outstanding, gained more than twice theBarclays standard gauge in 2012.

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

The Barclays Global Aggregate Bond Index, the most-usedmarket-capitalization benchmark for government and non- governmentglobal bonds, is weighted 36 percent to the U.S., followed by Japanat 18 percent. Japan has the highest allocation in the BarclaysGlobal Treasury Bond Index, which measures sovereign debt, at 29percent, followed by the U.S. at 27 percent. Mexico makes up about0.6 percent of the gauges.

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

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

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

Investors can't always get bonds of countries with the highestgrowth rates, such as China and India, amid restrictions on foreignownership, according to Chris Redmond, head of global bond-managerresearch at consulting firm Towers Watson.

Transition Phase

About 25 percent of Towers Watson's institutional clients aremoving away from market-based weightings in some part of theirholdings, London-based Redmond said in a telephone interview Dec.12.

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

“The industry is in a transition phase currently, but clearlymoving away from market-cap weighted benchmarks,” Orndorff, whosefirm 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 bythe changing allocations. They all have reserve currencies andcentral banks that have bought more than $5.3 trillion in bondssince 2008 to drive down interest rates and support theireconomies, according to Bianco Research LLC.

Yields on 10-year Treasury notes reached a record low in July of1.379 percent, those on Japan's benchmark bonds were a nine-yearlow of 0.685 percent in December and U.K. gilts dropped to a recordlow of 1.41 percent in July, according to data compiled byBloomberg.

U.S. 10-year yields were at 1.87 percent as of 6:49 a.m. in NewYork, from 1.84 percent at the end of last week. They reached 1.97percent on Jan. 4, the highest level since April. Japan's five-yearrate touched 0.14 percent today, the least since the governmentstarted selling the debt in 2000. Ten-year gilt yields were littlechanged at 2.05 percent.

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

Sales Soar

Sales of U.S. corporate and sovereign issues reached $1.1trillion in 2012, up from $962.8 billion the year before. GDPgrowth is expected to slow to 2 percent in 2013 from 2.3 percentlast year, according to the median estimate of economists surveyedby Bloomberg. Japan's economic growth is expected to slow to 0.7percent in 2013 from 2 percent in 2012, a separate surveyshows.

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

Movement away from capitalization-based bond benchmarks maycause higher borrowing costs for countries with elevated debt toGDP over the next few years, Jeffrey Frankel, a professor atHarvard University's Kennedy School of Government, said in atelephone interview Jan. 2.

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

Norway's Government Pension Fund Global, the world's largestsovereign-wealth fund, started weighting its euro government bondholdings in 2011 using GDP, and in July implemented a new benchmarkfor 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 globalindex developed in 2009 that weights countries by the size of theireconomy rather than indebtedness. The company developed the gaugeto reflect its outlook for a prolonged period of subdued returns indeveloped nations.

Pimco's Total Return ETF has gained 12.3 percent since itstarted trading March 1, 9 percentage points more than the BarclaysU.S. Aggregate Bond Index.

Even as it increased Mexican holdings and reduced the share ofTreasuries, the fund's dollar amount of U.S. debt increased. TheETF follows a similar strategy to the $285 billion Pimco TotalReturn Fund, the world's biggest bond fund.

BlackRock's Sovereign Risk Index, which was created in June2011, evaluates countries based on their likelihood of default,devaluation or above-trend inflation, Thomas Christiansen, astrategist at the BlackRock Investment Institute in London, said ina telephone interview Dec. 13. The measure takes into accountwillingness to repay loans and the term structure of the debt, hesaid.

The New York-based firm uses the index to reduce exposure tocountries most in danger of default, such as Greece, Portugal andEgypt, 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. “Werealized market-cap weightings essentially reward failures.Hopefully the longer-term implications are that some of thesecountries become more fiscally responsible.”

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.