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March 2020

The problem with passive bond funds

Passive bond funds are becoming popular with investors particularly the exchange-traded kind. The trouble is fixed income doesn't lend itself easily to index tracking.

It's difficult to find a duller-sounding investment than the passive bond fund. Nothing there to get the heart racing, you’d think. But the reality is rather different. As a recent report from the Bank for International Settlements (BIS) concludes, funds designed to track a fixed income index – such as exchange-traded vehicles – can in fact be rather risky.

The fundamental problem is that bonds simply don’t lend themselves easily to passive investing. There are several reasons why that’s the case.

The first is that, because the vast majority of bond indices are capitalisation-weighted, passive investors automatically load up on securities issued by the most indebted governments and corporations. That leaves them more exposed to unfavourable changes in a borrower’s creditworthiness than active investors, who can always vote with their feet.

Making matters worse for passive bondholders is that borrowing costs for governments and companies included in benchmarks fall as index-tracking funds attract more assets. This, in turn, incentivises even more borrowing – a development the BIS describes as a systemic risk.

Having a clear perspective on the creditworthiness of bond issuers is especially problematic for investors in corporate fixed income indices. As new bonds are absorbed into the benchmark, the credit quality of the index can sometimes change dramatically. A credit rating downgrade of a large company can have a significant bearing on the credit profile of the entire benchmark.

But being helpless in the face of a sudden shift in a bond issuer’s creditworthiness is not the only landmine passive investors face. There is also a structural weakness to bond ETFs: a liquidity mismatch.

In other words, the investment vehicle is often easier to buy and sell  - or more liquid - than the individual bonds in which it invests. 

When markets are calm and functioning normally, this isn’t a problem. But when markets are turbulent – as they have been in recent weeks with the spread of the coronavirus – this anomaly is potentially destabilising. Typically, the price of an ETF and the net asset value (NAV) of underlying investments move in lockstep. When an investor sells a bond ETF, it is usually purchased by a market intermediary. 

The intermediary then sells back the ETF to the fund issuer in exchange for the underlying bonds. Those bonds are then normally re-sold into the market, leaving the intermediary with a profit. 

Now, however, with broker-dealers becoming  more concerned about the creditworthiness of companies as the coronavirus spreads, they are less willing to engage in such transactions. When they do, they make the purchase at a much lower price.

This, in turn, has caused ETF prices to fall below that of the NAV of the bonds such vehicles hold. The gap has in some cases moved to as wide as 11 per cent.

Higher trading costs also make passive bond investing difficult. The turnover bond indices typically experience from one year to the next is considerable, far higher than that of equity benchmarks, and ranging between 30 and 70 per cent. For high-yield bond indices, it can be as much as 90 per cent. Tracking a bond index therefore requires a lot of trading, which increases investment costs. These costs have been estimated to be around 0.3 per cent per year for an aggregate bond index. Costs for lower-rated corporate or emerging market debt can be substantially higher. These implementation costs are rarely debated, yet are major flaw in index-tracking bond funds.

Finally, because regional or global bond indices can include up to 5,000 separate securities, indexation relies more often than not on sampling. But building an index in this way often involves using substitutes. In other words, to offset various costs, index managers often substitute bonds of higher quality but lower yield with ones of higher risk and lower quality. It is for this reason that index-tracker funds often experience sharper falls than their reference indices during bouts of market turbulence.

There is, then, nothing dull about passive bond funds. And that’s not a good thing.