Tuesday, November 8, 2011

Bond Market Irony and Karma: Why Evil Lehman Had it Coming

Rick Ferri recently blogged about how Total Bond Index Funds don't actually include the Total Bond Market. Ironic as it sounds, Rick is right.  Most so-called total bond market index funds try to mimic the Barclays Capital US Aggregate Bond Index (formerly the Lehman Aggregate Bond Index or in bond slang "The Lehman Agg"). Rick points out that the Barclay's Aggregate Bond Index EXCLUDES both junk bonds and TIPS.

TIPS (Treasury Inflation-Protected Securities) are an important asset class for investors since they are significantly different from traditional "fixed-income" bonds.  Thus, in my books, I utilize TIPS in many of my recommended investment recipes. TIPS are bonds issued by the US Treasury that adjust for inflation.  This is significantly different than all other bonds that pay a FIXED interest rate.

The biggest risk with investing in most US Treasury bonds is inflation risk.  If one looks at the current yield curve, you will see that 5-year US Treasury Notes currently pay less than 1% interest per year. If you own this bond, you will likely lose real value over 5 years as I expect inflation to exceed the paltry 1% yield.  TIPS also protect investors from DEFLATION as they are structured to never fall in value below their face value.  TIPS are so unique that when added to a traditional stock and bond portfolio, an investor can both reduce risk and increase returns of the overall portfolio.

Rick also points out that high-yield bonds (also called junk bonds or non-investment-grade bonds) are bonds issued by corporations with a credit rating lower than BBB- (i.e. BB+ or lower).  In Rick's blog, he recommends holding a high-yield bond fund.  I love Rick, but I respectfully disagree with him on this point. Junk bond returns are highly correlated with stock returns especially during periods when stocks fall in value.  Typically, when stocks go down, junk bonds also go down.  Since stocks will beat bonds over the long run, the only reason to own bonds at all is to smooth the ride for investors.  The only reason to own bonds is to help you keep your sanity when stocks fall.  Junk bonds don't accomplish that goal.  Utilizing portfolio optimization software, I have found that adding junk bonds to a diversified portfolio of stocks and bonds does NOT reduce risk or increase returns.

For example, if you are tempted to place 10% of your portfolio in high-yield corporate bonds, you would be better off (or no worse off) if you took that 10% and put 6% in a total stock index fund and 4% in a bond index fund (2 funds that should already be in your portfolio).  Plus, high-yield bond funds tend to have significantly higher expense ratios than broader bond index funds.  Since high-yield bond funds have higher expense ratios and don't provide diversification due to high correlation with stocks, I don't recommend most folks to add this unnecessary complication to their investment portfolios.

Rick also points out the irony that bonds that are issued by foreign entities, but issued in US Dollars, are included in the Barclay's Aggregate Bond Index while foreign stocks that trade on US stock exchanges are not included in US stock indexes.  I thought I would point out why or how this has occurred and point out additional irony.  Standard & Poor's (S&P) is famous for both its bond ratings and its stock indexes like the S&P 500 Index.  I think it is ironic that the worlds most famous bond rating firm does NOT have any popular bond indexes but does maintain popular stock indexes.  I've never understood that. (If you know why, please email me at InvestorCookbooks@gmail.com).

However, I do understand why S&P does not include foreign stocks in their US stock indexes.  Well, they are "US" stock indexes so that sort of explains itself.  The more interesting issue is why does the Barclay's Capital US Aggregate Bond Index include bonds issued by foreign entities?  The answer lies in who designed that index in the first place.  As I mentioned above, this index used to be called the Lehman Aggregate Bond Index.  Lehman Brothers was an investment banking firm that happened to create bond indexes to help their investors measure their bond portfolio returns.

Lehman, as an investment bank, helped foreign countries bring their bonds to market.  However, Lehman found it somewhat difficult to convince its customers to buy bonds issued by foreign countries - even if they were issued in US Dollars.  So, Lehman decided to wield their power over their bond indexes and started including these bonds in their indexes!  Lehman knew many if not most bond managers were measured against their Lehman Aggregate Bond Index.  As Lehman added more and more of these bonds issued by foreign countries to their benchmark indexes, bond fund managers - especially bond index funds - had to buy them.

I've spent part of my career managing bond portfolios.  The Lehman Brothers brokers I dealt with wielded their popular bond indexes like a weapon in other ways, too.  If we did not trade "enough" with our Lehman Brother brokers, they would take away our access to information about the Lehman Aggregate Bond Index.  It would be difficult to manage a bond fund that is measured against the Lehman Aggregate Bond Index, if we could not see what was in the benchmark the investing world measured us against.  Lehman essentially used their indexes as a competitive weapon against both their competitors and leverage over their clients tantamount to extortion.

You can add this to your list of examples as to why people believe investment banks are evil.  I shed no tears when Lehman Brothers went bankrupt.

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