Why We Don’t Like Bond Indexes

Why We Don’t Like Bond Indexes

Most investors know that most stock indexes like the S&P 500 are weighted by size or market capitalization as it is known in investment parlance. That means that the larger companies—in terms of value—comprise a larger proportion of the index. Apple is the largest company in terms of market cap, so it is the largest company in the
S&P 500 Index.

However, most investors don’t realize that bond indexes are weighted in the same manner—by size. The more debt a country, company, or county issues the larger the weight it holds within the index. Within the United States, the U.S. government is by far the largest issuer of debt, so it holds the largest weight in the Vanguard Total Bond Market Index Fund (58.6%).

This weighting methodology is why we recommend that our clients avoid investing in bond indexes. Automatically allocating funds to the most indebted countries, companies, and counties runs counter to prudent credit risk analysis. And the more debt these issuers take on, the larger their representation in the index becomes.

As a result, we advise steering clear of passively-managed bond index funds. Instead find an actively-managed bond fund, where the portfolio manager can decide which countries, companies, and counties deserve to borrow your hard-earned dollars. After all, to paraphrase the famous quote, bond investing is less about the return on your capital than the return of your capital.

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