A consortium of central banks has found a significant link between firms' bond-index weight and their leverage
Having become popular in the equity space, ETFs are starting to draw attention from investors looking for fixed-income exposure. But the growing interest in bond ETFs might also be leading firms to take on more debt.
According to new research from the Bank of International Settlements (BIS), there is a significant statistical relationship between firms’ weight in bond indexes and the degree to which they are indebted. “The largest issuers tend to [be] more heavily represented in bond indices,” the BIS said, as reported in the Wall Street Journal. “As passive bond funds mechanically replicate the index weights in their portfolios, their growth will generate demand for the debt of the larger, and potentially more leveraged, issuers.”
While large firms would be expected to issue more debt, the research by BIS had found that firms’ weight in the Bank of America Merrill Lynch Global Broad Market Corporate Index were more closely correlated with their leverage — whether counting all their debt or just bonds — than their size.
The BIS reported that as of June 2017, passive mutual funds managed about US$8 trillion, or 20%, of all investment-fund assets; that figure was up from 8% a decade earlier. The increasingly large flows of money into trend-following funds, some analysts fear, could exacerbate market movements; the risk is more pronounced for bond ETFs since debt markets are less traded and have more diversity than stocks.
“From a financial stability perspective, there is a concern that this [increased share of passive investors] can act pro-cyclically and encourage aggregate leverage,” the BIS said.
But on the bright side, passive-fund providers are already taking steps away from debt-weighted indexes. According to Bloomberg, 27 out of 48 US fixed-income ETFs launched late last year used alternative weighting factors, such duration risk or credit quality, in their underlying indexes.
The BIS has also acknowledged that while a company’s inclusion in a bond index could encourage leverage by driving extra demand for its debt, the reduced issuance costs and improved liquidity of bonds issued could also have beneficial effects.