Debt Crisis Highlights Bond Index Quirk

(Dow Jones) The debt crisis in Europe has highlighted one often-overlooked aspect of bond indexes: The more debt a company or a country issues, the bigger the role it typically plays in the benchmark.

That means investors in index funds or active bond funds that hew closely to these targets could have larger-than-ideal holdings of heavily indebted bond issuers like Italy or Greece, making such funds riskier than they might seem at first blush.

For traders and investors, indexes serve two important purposes: providing snapshots of day-to-day market activity and serving as measuring sticks for investments, especially mutual funds, whose performance is continually judged against these market gauges.

With stock indexes, those purposes dovetail nicely, at least in theory. When investors like a company, traders bid up the price of a company's shares, and the total value of the company surges relative to the rest of the market. Since stock indexes are weighted by these companies' total values, at any given moment the companies' weights in an index should reflect the market's view of their relative worth.

While fund managers and academics endlessly debate the accuracy of this popular wisdom, it's the basis for a lot of investment vehicles, especially stock index funds.

There are lots of funds based on bond indexes too, but here the weighting scheme doesn't necessarily work in the same fortuitous way. Often, bond indexes are weighted by the total value of an issuer's outstanding debt. However, a big debt level doesn't necessarily signal the market is bullish on an issuer's business prospects. In fact, a heavy debt burden can be a sign of weakness, one that indexes risk emphasizing.

For instance, in the Standard & Poor's Eurozone Bond Index, heavily indebted nations Italy and Greece represent 23% and 5.3% of the index, respectively, while financially healthier Germany represents 22%. If the index were weighted by another criterion, gross domestic product, or GDP, which arguably more closely resembles the market value used to weight companies in stock indexes, then Germany would represent about 27% of the index, Italy 17%, and Greece 3.3%. (Tweaks to comply with diversification rules for investments might shrink Germany slightly, but you get the picture.)

So why not just weight by GDP?

"It becomes an investment strategy rather than a broad benchmark for what is happening in the market" says J.R. Rieger, vice president of fixed income indices at S&P.

That's a good point. But investors who do use bond indexes as investment tools should be aware of this special dynamic.