Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

It's easy to see how cheaper indexed bond funds have been all the rage in recent years.

They have often outperformed their actively managed peers. They charge lower fees. They seem straightforward -- no secret sauce, no hubris, no mystery.

But the rise of these passively managed funds has also made U.S. bond markets more fragile. Namely, these funds enabled the borrowing binge by U.S. oil and gas companies, which are now struggling to remain solvent in the face of drastically lower oil prices. And they're spreading the pain of plunging energy values more widely to the biggest and smallest debt investors.

Here's the logic behind this. Passive strategies seek to track broader indexes, allocating more money toward borrowers that have larger amounts of debt outstanding. In other words, the more bonds a company has sold, the more heavily represented it will be in the index and will attract a greater amount of money from passive funds, regardless of its business plan.

Passive bond funds have been incredibly popular, especially in the past three years, attracting a surging amount of money even as active bond funds experienced withdrawals. U.S. managers tracking indexes oversaw a record 27 percent of the money in taxable-bond mutual funds and exchange-traded funds as of Feb. 29, compared with 20 percent at the end of 2013, according to Morningstar data highlighted by Bloomberg News reporters Charles Stein and John Gittelsohn in an article on Friday.

In part, their popularity stemmed from central-bank stimulus that suppressed benchmark yields, fueling bigger returns on the riskiest corporate debt. These policies made bonds an almost sure-fire win; the faster and more cheaply investors could buy the stuff, the better for them.

Energy companies took advantage of this by leveraging up drastically. The riskier oil and gas companies have more than tripled their debt since the end of 2008, with their bonds outstanding rising to a face value of $234 billion from $70.2 billion, Bank of America Merrill Lynch index data show. Their debt became a bigger proportion of benchmark indexes that passive strategies used as road maps for what to buy. Leverage begot leverage begot leverage.

Borrowing Boom
U.S. energy companies tripled their debt on the heels of easy-money policies
Source: The BofA Merrill Lynch US High Yield Energy Index

During this time, investors weren't necessarily deliberately enthusiastic about energy companies. They weren't making a bet on the direction of oil prices. They were simply following the changing composition of indexes, which included a growing proportion of oil and gas debt.

Energy Bloat
Energy debt accounted for a bigger proportion of overall junk-bond indexes in recent years
Source: The BofA Merrill Lynch US High Yield Index

That was all well and good until 2014, when oil prices plunged by 50 percent in about six months. Suddenly, the business models of many U.S. energy companies were called into question. Junk-rated debt of such borrowers lost about 13 percent in the period. Since June 2014, an estimated $65.1 billion of market value has been eliminated from U.S. junk-rated energy bonds.

The pain may not be over, by any means. Since 2015, more than 50 North American oil and gas companies have sought bankruptcy protection, with many more expected.

It's not as if all active managers successfully avoided the oil boom and bust in debt. But some did. And the more a herd-like mentality takes over the market, the more fragile it becomes.

While energy is a prime example of this, it isn't the only spot where indexed funds have rewarded companies for incurring loads of debt for questionable endeavors.

Consider Valeant, for example, which borrowed more than $19 billion over the years and is now grappling for its survival and considering selling off its assets to remain solvent. Or Sprint, which is trying to figure out how to pay back more than $26 billion of debt after being downgraded and losing favor with many investors.

Perhaps it's attractive for investors to pay much lower fees to get into taxable bond funds now. But they're blindly trusting that companies and nations are borrowing money responsibly without relying on human fund-manager judgments about whether this is the case.

Down the line, it may be more expensive for them (and everyone else) when big borrowers turn out to be unworthy of the easy credit they've received.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net