Summary Avoiding an indebted investment is short-sighted, because data shows that debt levels and returns aren’t always negatively correlated. By tilting to the segments that are more sensitive to movements in credit spreads, investors must be willing to accept the greater influence of the equity markets. Look at the data before you believe a strategist who encourages you to avoid indebted companies. By Chris Philips Late last year, Josh Barrickman, head of bond indexing at Vanguard, blogged about the smart beta movement in fixed income. Josh challenged the notion that a company or country could flood the market with debt, which would invariably harm market cap-focused investors. You’ve probably heard it before: “Why would anyone want to invest in the most indebted companies or countries? It’s just throwing good money after bad.” While this premise may seem logical and intuitive on the surface, as with many things we see or hear, a bit of logic and perspective can diffuse superficial arguments. First, some perspective from a unique source. I’ve been catching up on some reading, and one piece in particular stuck with me – an article referencing a story about astronomer Carl Sagan. When presented with “evidence” of alien abductions in the form of an individual who was convinced beyond doubt of having been abducted, the astronomer responded: ” To be taken seriously, you need physical evidence… But there’s no [evidence]. All there are, are stories .” So, should we believe the stories and fear debt? The answer is, it depends. But as a general practice, avoiding an investment simply because of its level of debt is short-sighted. For example, see Figure 1, which shows the relationship between a country’s debt-to-GDP level and the returns of that country’s bond market. Included is a mixture of developed and emerging market countries, with a requirement that each country report a debt-to-GDP ratio and 10 years of bond returns. I’ve highlighted two “groups” of countries – those that have seen low returns over the last 10 years and those with higher returns. Notably, there’s no apparent relationship within each group or across groups. Higher debt levels didn’t always lead to lower returns, and low debt levels didn’t always lead to higher returns. So, rather than take intuition at face value, as investors we must ask ourselves: “What causes one country with a low debt-to-GDP ratio to return 1.5% per year, another to return 4% per year, and yet another to return 7.5% per year?” Clearly, market participants are taking many more factors into consideration than just the perception that debt is scary and should therefore be avoided. Figure 1. Another consideration involves the actual portfolio ramifications of focusing on debt levels as a screening metric. The easiest strategy with which to evaluate the impact of debt involves weighting an index according to a country’s GDP instead of to its bond market. And if we compare the Barclays Global Aggregate Bond Index to the GDP-weighted Global Aggregate Bond Index, we see an immediate attraction: Duration is reduced marginally from 6.47 to 6.33, but the yield increases by close to 20% – from 1.72% to 2.06% – by moving to the GDP-weighted index.¹ Less risk and greater return? Free lunch alert! However, if we closely examine Figure 2, we can clearly see what’s going on. By moving away from market cap, you underweight the U.S. and Japan and overweight various emerging market segments. After all, the U.S. and Japan both fit the profile of the most indebted countries. One implication is that while both indexes are considered investment-grade, the GDP-weighted version has a noticeable tilt towards lower-quality bonds. Figure 2. Why is this important? Because as much as we’d like them, free lunches do not exist. Case in point: From January 1, 2008 through February 28, 2009 (the last notable equity bear market), the Aaa segment of the Global Aggregate Bond Index returned 0.2%. The Aa segment returned 5.8%, the A segment returned -17.1% and the Baa segment returned -14.0%.¹ In other words, by tilting to the segments that may be more sensitive to movements in the credit spreads, investors must be willing to accept the greater influence of the equity markets, particularly during really bad times. What’s more – and what’s important – is that a primary motivation for holding fixed income (at least in our opinion) as a consistent and meaningful diversifier for equity market risk may be marginalized (see: Reducing bonds? Proceed with caution ). My advice? Next time you hear a strategist, sales executive, or portfolio manager encouraging you to avoid indebted countries or companies, ask yourself whether you should buy into the hype. Indeed, as Sagan is famous for stating: “Precisely because of human fallibility, extraordinary claims require extraordinary evidence.” So, let’s all take a deep breath and repeat: “I’m not afraid of debt, I’m not afraid of debt.” Source: Barclays Global Aggregate Bond Index. Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Securities of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.