Brettarends

If you think this ends with Greece and Italy, you’re crazy. The Japanese government has gross debts of nearly $15 trillion, says the International Monetary Fund. The United States government, depending on how you calculate it, has about the same. Western governments almost everywhere are in a sea of red ink.

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And here’s the kicker: These governments are still finding it easy to raise new money, from people like you, because of a massive, fundamental flaw in the way the global bond markets operate.

We all know now how boring, technical-sounding details in the U.S. credit market helped create the mother of all bubbles in the housing market five years ago. Now consider this: Something similar, but much bigger, is taking place in global bonds.

Why? In a nutshell, the global bond markets are set up in order to lend the most money to the countries which are already most in debt, regardless of their future ability to pay. And they will lend the least to those who have the best future prospects.

Crazy? Ridiculous? No kidding. Not for the first time, I find myself thinking: This is so stupid, only experts could have thought it up.

Rob Arnott has the story. He’s the chairman of Research Affiliates, a prominent money management firm in Newport Beach, Calif. He thinks the global bond markets are deeply flawed, and will today, in partnership with Citigroup, unveil a new set of bond market indices to try to fix the problem.

The issue, Mr. Arnott says, is that most global bond market indices are basically weighted by the capital value of national bond markets. The countries with the biggest bond markets make up the biggest weighting in the global indexes. Sound sensible? Hardly. In bonds, he says, cap weighting means that you weight bonds in proportion to a borrower’s debt. A moment’s thought makes you realize that this is upside down of what an investor actually wants. If you’re a bond investor, you’re a lender, Mr. Arnott says. Why on Earth do you want to lend more to whoever has the most debt? And why would you have to lend them more if they have to borrow more?

Let’s talk numbers. Japan accounts for just 8% of world economic output, but a stunning 29% of the bond market — and 32% of the market for developed market bonds. That’s far bigger even than the U.S. share, even though Japan’s economy is far smaller. Japan’s bonds also pay paltry yields, so you are getting ill-compensated for your risks.

If you were to buy a typical global bond fund today, one of your biggest investments would be the bonds of … Italy. They’d get almost 6% of your money — compared to 10.5% for all emerging markets put together. The reason? Italy has the third largest debt of any country in the world. And so the bond indices weight it appropriately.

Nuts.

Japan and the United States, between them, make up almost 50% of the global bond market, simply because they have borrowed the most.

There is no perfect alternative. But Mr. Arnott, reasonably, argues bond investors ought to lend money based on ability to repay, and he has come up with a way which he believes approximates it.

Instead of weighting countries according to their debt levels, the new Citi RAFI bond indexes will weight them using four factors: Gross domestic product, energy consumption, population, and resources. Used together, Mr. Arnott argues, these offer a reasonable proxy for a country’s ability to repay its obligations, today and in the future.

Why?

GDP and energy consumption are proxies for a country’s capital base and ability to use it. Population is a proxy for labor. As for resources, Research Affiliates use the square root of each country’s land mass. (The square root, he says, so we don’t reward Russia with a vast allocation, and punish (tiny) Leichtenstein.) Just using GDP, he says, would ignore a country’s future ability to pay; it would give too little weight to emerging markets. A country that borrows money today will be paying it off over the next twenty or thirty years.

Using these numbers changes a bond portfolio dramatically. Look, for example, at how it re-rates just the developed markets.

Japan’s share of the developed bond markets index under this method plummets from 32% to 9%. Canada jumps to 8%, Germany to 7%, just beating Australia. (The U.S. share drops from 26% to 21%). Italy drops from 6% to less than 5%.

Mr. Arnott says that following this methodology in the past would have added about one percentage point a year, on average, to a developed bond fund’s return. Over any decent period of time, that is a hefty improvement.

The two new Citi RAFI bond indexes are based on this methodology: One for developed markets, and one for emerging markets. A global index will follow in due course. It will, inevitably, lead to a dramatic reallocation towards emerging markets.

It’s sensible and long-overdue. The current system enabled Greece to borrow cheaply money that it cannot and will not ever repay, and yields barely half a percent above Germany’s. It means investors pouring money into global or international bond funds are inevitably lending truckloads of money to Japan, for no obvious reason and at minuscule interest rates.

Mr. Arnott’s advice to investors right now is to own more emerging-market bonds (and emerging-market stocks). Emerging markets account for 45% of world GDP, he says, but just 10% of world sovereign debt.