Risk budgeting techniques in bond indexing.

In August 2011 Standard and Poor's downgraded the credit rating of US government debt from AAA for the first time. Even five years ago, such an event would have seemed very unlikely; historically, the debt of major developed countries has been considered almost free of credit risk. However, the 2008 financial crisis and the resulting global recession have played havoc with this conception. Sovereign issuers' creditworthiness is now under increasing scrutiny, especially in Europe¹, while bond investors now face a significant new challenge—one that's especially important for those using a passive, index-based approach.

Traditionally, bond indices have been constructed according to the methodology of weighting by market capitalisation. This means that each country in the index is given a weight proportional to the level of its outstanding debt². The simplicity of this approach and the recognition of a capitalisation-weighted index as the "market portfolio" has contributed to the success of the methodology. Yet, intuitively, it is easy to note a basic flaw in this allocation scheme, since it gives higher index weightings to the most indebted countries, regardless of their capacity to service their debt. A country facing financial hardship and trapped in a debt spiral to remain solvent would see its index weight increase until the whole mechanism collapses and an exclusion from the index occurs. Depending on the index, exclusion can be triggered by specific events, such as by a downgrade or, in the worst case, by a default.

The case of Greece illustrates this point. Since the beginning of the financial crisis, Greece has struggled with a high debt and refinancing burden. As the country relied more and more on borrowing, the weight of Greek debt increased in European bond indices until the point where Greece was downgraded and excluded from some of the key indices. Passive investors then had no choice but to sell their distressed bonds into a depressed market, leading to significant losses. From the perspective of efficient markets theory, such a risk could be acceptable if it were compensated by an additional return, resulting in similar risk-adjusted returns from the debt of different countries. However, this does not seem to be verified in practice, as Robert Arnott has pointed out (2010).

Another approach to bond indexing is to base weightings on fundamental data. The underlying idea is that weightings should reward those countries with high income, rather than those with high levels of debt. Toloui (2010) proposes to weight country exposures by GDP instead of by outstanding debt. This approach has the advantage of addressing some of the shortcomings of capitalisation-weighted indices:

• It allocates more to less indebted countries.
• It does not have a backward-looking bias, unlike capitalisation-weighted indices (which reflect past patterns of debt issuance).
• It does not suffer from the "buy high, sell low" problem characteristic of the capitalisation-weighted approach.

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