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Pragmatic Capitalism

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Are market-cap-weighted fixed income benchmarks theoretically sound?

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It’s often said that market-cap-weighted fixed income benchmarks are logically flawed because bond issuers determine the index weights. The more bonds a given entity (eg, company, government, etc) issues, the greater its weight in the applicable index. To quote a piece from Pimco:

“Bond indexes are different. Weightings chiefly reflect how much debt a company or government issues and the size of an individual security issued. Yet if a company issues more debt, the aggregate value of the enterprise is not fundamentally affected: Cash coming in is an asset; debt added is a liability. Ignoring issuance fees, new cash – new debt = 0. However, when a company issues more debt, its weight in a bond index increases. Why should a company’s decisions on capital structure drive an investor’s decision to hold its bonds? Why should an investor boost holdings in a company’s liabilities because the company increases financial leverage?” (full article: https://www.pimco.com/en-us/insights/viewpoints/viewpoints/bonds-are-different)

This concept has never made sense to me. Presumably if an issuer is over-leveraged the price of the issuer’s bonds will reflect this (that is, the price will be lower and thus the weight of that issuer in the index will decline).

I’d be curious to hear your take on this, Cullen, and the views of the other forum participants. Thanks.

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Posted by Sean
Posted on 02/16/2017 3:41 PM
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Hi Sean,

Yeah, this is a real problem. It’s part of why I think you can’t call anything “passive”. In other words, the financial markets are a living thing that change dramatically over time. Owning the current market cap of outstanding instruments often ignores the fact that those markets are changing due to new issuance. So, owning the S&P 500 doesn’t account for the market cap of new instruments.

This is even more exaggerated in the bond markets because bond issuance occurs so much more often. Owning a bond fund doesn’t really reflect the aggregate market of outstanding bonds. It probably gets close enough, but you still own something that deviates from the true market cap weighting.

Make sense?

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Cullen Roche Posted by Cullen Roche
Answered on 02/17/2017 3:24 PM
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