Investing in financial instruments that track a bond index may not be the wisest thing you can do.
Bonds are very different from equities when it comes to passive management (index-tracking), Andrew Canter, the chief investment officer of Futuregrowth, Old Mutual Investment Group SA’s bond specialist boutique, argued at a recent presentation.
Simply put, companies and institutions with the most debt will make up the biggest slice of a bond index, whereas companies that make the best profits will dominate an equity index.
Or, as Canter put it put more crudely, a corporate bond index in the United States in early 2001 would have been dominated by energy company Enron, with its massive known debt of US$13 billion (and another US$10 billion in hidden debt), while its major competitor, Exxon, had very little debt on its books.
And, currently, a Greek or Italian government bond index does not look that healthy.
The consequence of com-panies such as Enron and countries such as Greece, which teeters on defaulting on its bonds, is a massive smack for passive investors in the bond market. So investing in the underlying securities that make up a bond index may be a lot more risky than the shares that comprise an equity index, because a bond index is not as representative of an economy in the way an equity index would be.
To be fair, though, equity investors would also have been adversely affected in the case of Enron, because its share price was massively over-valued at US$83.13 in December 2000 (resulting in a market capitalisation of US$74 billion, which was six times its net assets). The share price dropped to zero a year later because the company was unable to repay its debt.
While Enron may not be a good example, because fraud and creative bookkeeping were involved, the argument against passive investing when it comes to bonds does make some sense.
Canter is not arguing against investing in bond markets. What he is saying is that investments in bond markets must be actively managed because, as he puts it, “all debt is not created equal”.
Debt comes in many different forms, such as:
* Secured debt, where there is an asset that the lender can claim if the borrower defaults on repaying the loan; and
* Unsecured debt, where a default will leave the lender with little or nothing.
Debt also offers returns based on the assessed level of risk, which affects the interest rate.
The conventional wisdom is that, in order of risk (based on the potential to lose all or some of your capital), the safest places to invest are: cash (bank deposits and money market funds), bonds (loans to governments, para-statals and companies), property and equity (ownership of shares in companies).
Think again.
One of the problems facing investors is the development of a financial system that tends to hide the true levels of risk until things go very wrong.
It happened in 2008, when banks irresponsibly created the subprime credit crisis by trading contaminated bundles of mortgage debt (securitisations), which landed up in both money market funds and bond funds.
It is happening again now, with expectations that there could be defaults not by com-panies but by governments in Europe, which have issued what are normally referred to as “gilts”: bonds that are supposed to be beyond doubt.
Canter argues that you need an expert who actively manages a bond portfolio to sort out the potential defaulters and to seek out the best risk-return profiles you can get.
Those bond portfolio managers who in the past relied almost exclusively on credit rating agencies to assess risk can no longer do so. They have had to join those who have been treating the credit rating agencies with some justified scepticism.
Both the Collective Investment Schemes Control Act (which regulates unit trust funds) and the redrafted regulation 28 of the Pension Funds Act now require asset managers to perform their own assessment of risk.
Canter argues that almost any bond manager can out-perform a bond index – which is definitely not the case with an equity index, where very few equity fund managers out-perform the index on a sustainable basis after costs.
However, the challenge for individual investors remains how to select an active bond manager who will out-perform – particularly inflation by three percentage points or more – on a sustainable basis.