... Or why the global investor should consider fundamental indexing for sovereign bonds.
By William de Vries (Head of Core Fixed Income at Kempen Capital Management) and Hans Kamminga (Senior Portfolio Manager Fixed Income at Kempen Capital Management)
International capital markets, and certainly international sovereign bond markets, are perceived to be liquid and efficient. But we doubt whether these are perfect markets, which means that the yield on a sovereign bond is the fair reflection of all information available to the investors. Given the fact that movements on these markets are dominated by non-rationale choices of policy makers and the public, investing in sovereign bonds by using a market cap weighted bond index does not seem a wise choice. This explains the recent interest for the so-called alternative beta investment strategies for bonds. In the case of sovereign government bonds, there has been a major contribution in this area by Rob Arnott and Jason Hsu of Research Affiliates (RAFI), who are the founding fathers the “fundamental” index approach for sovereign bonds.
Bond investors who sought the safe haven of German bunds in the last four years have experienced high returns. They profited from the flight to quality which resulted in bund yields clearly below 2%, But now, given the low yields in most of the high quality (AAA) debtor countries, people start to wonder whether is possible to build a more internationally diversified sovereign bond portfolio that still makes sense with regard to default risks? The euro crisis has clearly shown what happens to investors that invest their international sovereign portfolio in line with a market cap weighted bond index. The largest debtor countries in the world become the biggest part of the portfolio, in order to control the relative risks. But do you really want to invest the major part of your portfolio in big debtor countries like the United States, Japan, Italy and France? These four sovereigns have a weight of more than 70% in the standard market cap weighted index. And it does feel even more uncomfortable knowing that the yield on the sovereign bonds of these four countries seem artificially low as the result of the massive quantitative easing policies of the Central Banks in these countries. The normal market mechanism that the largest debtor should pay a higher yield as a result of higher perceived default risk does no longer seem to work. RAFI has developed a fundamental indexing strategy for sovereign bonds, which offers a well-diversified global bond portfolio. Key for this strategy is that no longer the market cap decides the weight of a country in the index, but instead the country weight is determined by the economic footprint of a country in the World economy. This way one does avoid the pitfall of the greatest debtor country having automatically the biggest weight in a sovereign bond portfolio. Within this strategy the weight of a sovereign is determined by 4 independent variables that are rescaled annually. The country allocation is based on the idea that long term, only sovereigns that have the capabilities and economic resources to create a sustainable economic growth are able to pay back their debts. This strategy makes perfect sense, and back tests prove that the fundamental index approach delivers a more robust long term solution if you consider a more global diversification in sovereign bonds. It delivers a better return, and at the same time is the return is less volatile as the portfolio is better diversified.
So perfect sense in theory, but how does this work out in practice ? At the end of 2011, Citigroup and RAFI together started the Citi RAFI Sovereign developed market index series to reflect the exposure to 22 developed sovereign bond markets.
Comprendre l'économie durable pour s'y investir