Surprise! You Probably Own Some of Verizon's Bonds

Bond investors who use ETFs for their fixed-income investing have largely focused on just one thing lately: the losses they've suffered as rising interest rates have caused bond fund prices to fall. Yet the more recent massive offering of $49 billion in bonds by Verizon (NYSE: VZ  ) highlights another characteristic of bond index mutual funds and ETFs that many investors don't fully appreciate: Many indexes that bond funds track give greater weightings to the companies that have the most outstanding debt.

What that means to you is that if you own a bond fund, you probably just signed up to take on a much bigger chunk of Verizon's debt -- just when it got a lot riskier to own.

The ins and outs of bond indexes
Stock index investors are familiar with the way that stocks get weighted by market capitalization in most ETFs and index funds. Despite the shortcomings of that methodology, it has the benefit of rewarding those companies that have generated enough financial success to support a rising share price. In most cases, market cap will bear at least some relation to the value of a company's assets and its future earnings potential, so stock fund investors end up with more of their fund assets invested in those promising companies.

But many bond indexes focus on the liability side of the balance sheet, looking at the total outstanding value of index-eligible debt that a company issues. As a result, bond funds end up rewarding those companies that take on more debt, even when the additional debt causes those companies' balance sheets to deteriorate markedly.

That's arguably what has happened with Verizon. With the $45 billion in fixed-rate bonds counted toward Verizon's total outstanding debt, the telecom giant will jump to No. 4 in one popular benchmark of investment-grade corporate bonds once the index rebalances itself at the end of September. Bank of America ranks third with almost $80 billion in debt, trailing only banking rival JPMorgan's $84 billion and No. 1 General Electric's $90 billion.

Yet in the eyes of bond-rating agencies, Verizon's debt got less attractive. Both S&P and Moody's downgraded the telecom's debt ratings by a single grade, with S&P lowering it from "A-" to "BBB+" and Moody's taking it down from "A3" to "Baa1." The huge boost in leverage will put more pressure on Verizon to produce cash flow to finance debt payments, even as the issuance of new shares will increase the amount of money shareholders receive in dividends -- assuming that the company keeps its payout stable. Of course, Verizon believes that taking full control of Verizon Wireless will provide that cash flow, but the risk is still there.

A repeat performance
This isn't the first time that bond indexes have been criticized for their methodology. Prior to the financial crisis, U.S. government debt made up about 35% of the Barclays Aggregate Bond Index. But during the crisis, the U.S. government greatly increased its issuance of debt to finance stimulus spending, and its takeover of government-sponsored mortgage entities Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac (NASDAQOTCBB: FMCC  ) also boosted its shares of overall debt levels. By mid-2012, direct government obligations approached half of total bonds in the index. Adding in Fannie and Freddie obligations, which reflect the massive infusion of capital the government put into those entities, the government-debt share in the index rose to about 78%.

That figure has come down slightly, as government borrowing has slowed and corporations have ramped up their debt issuance. Nevertheless, investors in the iShares Barclays Aggregate Bond ETF (NYSEMKT: AGG  ) and other funds that track the index have much more exposure to government debt than they did previously, and that has raised concerns about how vulnerable fund shareholders may be to rising interest rates that could affect government debt more than corporate debt.

Watch out for your ETFs
To see whether you'll end up owning more Verizon bonds, you'll need to look at how the particular index your bond fund tracks determines which debt to buy. For the popular iShares iBoxx Investment Grade Corporate ETF (NYSEMKT: LQD  ) , which is a huge player in the bond ETF market with $17 billion under management, use the Markit iBoxx USD bond indexes, which rebalance every month. Other investors use the Barclays Corporate Index, which similarly should include Verizon's debt by early October.

The size of Verizon's debt offering makes it a particularly noteworthy example of this phenomenon. But the concentration of debt from high-volume bond-issuers should give you equal cause for concern if you're seeking a safe, diversified portfolio. With the structural elements of bond indexes supporting the counterintuitive weighting methodology, you have to be careful using index-tracking bond funds for your fixed-income exposure.

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