It has become popular to blame passive investors and index funds for the recent rise (and fall) in prices for U.S. high yield bonds. The thesis – placing passive investors as the culprit – goes as follows:
- There have been material, positive flows into passive bond funds, at the expense of active funds.
- Passive bond funds typically track indices that are market-cap weighted, that is, with a higher weight in issuers that have a greater value of outstanding debt.
- Such trends have rewarded the most-indebted companies with an “irrational” demand for their bonds.
- Energy companies in particular have been able to ramp-up a debt-fuelled binge, the eventual popping of which we experienced earlier this year.
We cannot fault anyone for nodding in agreement; the reasoning is certainly seductive. And its variants have found support. Certainly, large flows of capital into (and out of) an asset class have the ability to create, and pop, bubbles within that market segment. But the argument – assigning importance to the relative popularity of passive funds – is fatally flawed.
Imagine, for a moment, that we could split the U.S. high yield bond market into two categories: those securities owned by the passive investors, and everything else, which is owned by the active investors. Each passive investor – new or existing – is required to hold bonds issued by energy companies in proportion to their overall market capitalization, while we suppose that each active investor may individually choose their preferred allocation.
Now, here’s the logical trick: since the sum-total of active and passive investments matches the market, the proportion allocated to any market segment by active managers must, in aggregate, equal the allocation made by passive investors. This is just arithmetic, based on the fact of both passive investors and the overall market having the same weights in each segment. To emphasize:
The proportion of capital allocated by active investors, in aggregate, to high yield energy bonds was, is and forever shall be precisely in proportion to market capitalization.
At the point when a new passive investor entered the market (or an existing passive investor increased their allocation), he or she bought high yield energy bonds in the same proportion as the active investors, and maintained their allocations similarly.
Given this fact, one might be wondering, at this point: what it is that active investors in aggregate do exactly? Here’s the rub:
Active investors set prices.
The weighting of each security in a market-cap bond index depends on both the issuance amount and the price of the security. If an energy company is viewed as a poor prospect to repay their debt, active investors – if they are paying attention – will only buy their bonds at a lower price, and will sell them if the price is unduly high. In this way, active investors determine the market capitalization of any individual company’s bonds.
This applies to the primary (issuance) market, just as much as the secondary market. It also applies to investors deciding whether or how much to invest in the U.S. high yield market in the first place, which similarly occupies a proportion of the overall U.S. bond market that is determined by the activities of active investors.
Thus understood, the “bubble” in high yield energy debt was not created by the simple issuing of debt by oil companies. Nor was it created by passive investors, or a shift from active to passive bond funds. Instead, as was the case with every bubble before and since, it arose through ACTIVE decisions to purchase securities – or market segments – whose price in hindsight seems unjustified.