Domestic bond market indexes leave out a lot of the bond market. Three firms that have widely used indexes -- Lehman Brothers Inc., Merrill Lynch & Co. and Salomon Smith Barney Inc. -- only scratch the surface when it comes to the enormity of the universe of potential investments. The time might have come for a major overhaul.
Federal Reserve data show $22.6 trillion in total credit market debt, domestic and foreign at the end of September. This was debt held domestically.
By comparison, recent Lehman Brothers' reports track $6.8 trillion in its domestic indexes. This is the combined market value of the aggregate index ($5.4 trillion), the high-yield index ($321.8 billion), the adjustable-rate composite index ($191.8 billion), the investment-grade 144A index ($76.1 billion), the private placement index ($67.9 billion), and the municipal index ($666.9 billion). Before going further, one needs to adjust the market value of the Lehman data to par value, which is what the Fed does with its data. Thus the Lehman data drops to $6.3 trillion.
Why the differences?
The Federal Reserve lists six categories of mortgages or mortgage-pool securities with a total value of $7.6 trillion compared with the fixed- and adjustable-rate mortgage-backed securities tracked by Lehman and valued at $1.8 trillion, which is just 23% of the potential universe. All of the Lehman issues are U.S. agency pools. The Federal Reserve shows $4.3 trillion in home mortgages over and above $2 trillion in mortgage-pool securities.
Maybe this all does not trade, but then maybe again a good portion does. With Wall Street's success with securitization, any debt can be fair game for secondary trading at some time.
Today, with all of the sophisticated tools for managing bond portfolios, investors need to remember they are managing, after all, portfolios of old-fashioned loans. Furthermore, today's securitization technology makes it possible for virtually all loans to trade.
Among other differences, the Fed lists $877.2 billion in commercial mortgages, for which Lehman recently introduced an index with a value of just $68.1 billion. According to financial data reported by Bloomberg LP, commercial mortgage-backed securities issuance totaled $24 billion in 1996, $39 billion in 1997, and $79 billion in 1998, for a total twice as great the new index. In addition, the Fed lists $93 billion in farm mortgages.
Back to the residential loans, most market participants are aware of whole-loan collateralized mortgage obligations. At the end of 1997, according to Bloomberg, there was $135.2 billion in whole-loan CMOs outstanding. These have been around for years, but as yet are not in any index. Also, raw loans can be pooled and traded like the agency ones.
One should ask why no CMO indexes have developed. The usual argument given is that the collateral for CMOs, at least agency ones, is already counted in the big indexes, which means the performance of CMOs in total is measured by the performance of the collateral. But that still does not help an investor to see what the performance of different types of CMO tranches has been. At the end of 1997, according to Bloomberg, there were $828.5 billion in CMOs outstanding. CMOs have been big business for Wall Street since 1983, one would think they could come up with a series of indexes for them.
Some of the myriad alternative investment ideas worthy of consideration in the mortgage area include Federal Housing Administration project loans, Federal National Mortgage Association delegated underwriting and servicing issues, and Federal Agricultural Mortgage Corp. agricultural mortgage-backed securities.
Participants in these areas know they offer wider spreads and better structure than their single-family pool counterparts.
Another category with a big difference is U.S. agency debt. The Fed lists $1.2 trillion vs. Lehman at $425 billion. Agency issues worthy of consideration include debt from the Agency for International Development, the General Services Administration, and the Maritime Administration. Incidentally, Lehman dropped Maritime Administration Title XI debt from the government index in January 1990.
Other issues to be considered are Small Business Administration development company participation certificates. Neither public nor private, much agency debt is exempt from registration with the Securities and Exchange Commission.
The Fed provides enough categories to distinguish financial, non-financial and foreign corporate debt (Yankee bonds). These categories, respectively, amount to $1.8 trillion, $1.6 trillion and $416 billion. Grouping these subsectors of Lehman's data shows the counterparts at, respectively: $322 billion, $1 trillion and $198 billion.
Because of a liquidity requirement, a lot of good publicly issued corporate debt is overlooked by the indexes. The Fed lists $2.5 trillion in bank loans and other loans and advances. Lehman has a Corporate Loan index that tracks 40 term loans, but no market value data could readily be found.
The final category to mention is consumer credit, which the Fed lists at $1.3 trillion. The Lehman Asset-Backed Securities index, by contrast, has $50 billion. In fact, in another grouping, the Fed lists $1.3 trillion in debt from "issuers of asset-backed securities." Interestingly, Morgan Stanley Dean Witter & Co. estimated the ABS market to be $525 billion at the end of the third quarter, 10 times the size of Lehman's index.
In fairness to Lehman Brothers and the other index providers, to build workable indexes they must draw the line somewhere, and a good place to start is with liquidity. Lehman, for instance, requires all issues have more than $100 million outstanding. Even so, Lehman had 6,860 issues in its aggregate index at June 30, 1998. One has to remember the Dow Jones industrial average tracks just 30 stocks.
The domestic debt market is massive. The task of creating, maintaining and pricing a true, comprehensive benchmark is tough. Pension plans and other fixed-income investors should consider the implications for performance measurements in using benchmarks for portfolios that could hold securities not in typical indexes. When confronted with data showing the domestic bond market is two to three times greater than that captured by the indexes, one might wonder what value can be found off the beaten path.
Douglas Folk is vice president at Investek Capital Management, Jackson, Miss.