A bond index is made up from the prices of selected bonds. This pool of investments aims to provide an income by matching a particular bond index. And while people may like to believe that fixed income is safe, it suffers from the same affliction as any indexed fund: the whole is only as strong as its weakest component.
That means that the biggest issuers are the biggest component of the index, but unlike stocks, where you invest in companies that are doing well, when you issue more bonds, you are actually dealing in more debt. Bob Swan, Vice-President of Canso Investment Counsel, told Financial Pipeline editor Romina Maurino that his can lead to a liquidity issue, because while you can give the order to sell at any time, you don’t really get to choose what part of the fund to get rid of.
The first one of them is liquidity problems. Let me try and give you an example, let’s say for instance that there’s an index of the four major developing economies, Brazil, Russia, India and China. And the indexer has created a product that has, say, 25 per cent in each of those different areas. Then you get into a situation where the price of oil falls, which is of course Russia’s largest export, and so investors decide they don’t want to be in Russia. They prefer to be in India where the growth prospects are great, maybe even because the price of oil has been falling (and) India imports. So you got this relative shift in the attractiveness of the different components.
Now let’s say for instance that people get worried about China and say, “Oh, I got to sell that ETF or that product I have that has these four parts in it (the big one being China),” then what can they sell? When the manager wakes up in the morning and sees this huge sell order, the only thing he can do is sell the component of its portfolio that is liquid (where there is demand for it). So he can sell India, because India’s attractive, he can’t sell Russia and a consequence of this is that as his fund changes shape over time, you have more and more of the fund committed to the weakest components in it.