NEW YORK ( TheStreet) -- If you buy Vanguard Total Bond Market Index (VBMFX), you have a big stake in Treasuries and tiny holdings in debt from such blue-chip corporate issuers as International Business Machines (IBM - Get Report) and Wal-Mart Stores (WMT - Get Report).
The Vanguard portfolio, which tracks the Barclays Capital Aggregate Bond (LAG) index, seems lopsided because it is weighted according to market capitalization. Under that system, Uncle Sam and other issuers that are heavily indebted account for a big weight in the index, while borrowers with little debt outstanding count for a small percentage of total assets.
In effect, bond investors loan the most money to people who may have trouble repaying. That is not the best way to invest, says Ramin Toloui, executive vice president of Pimco, which runs the world's biggest bond mutual fund. "You wind up with a distortion when large issuers of debt have higher weights in the index," Toloui says.
To take a different approach, Pimco has devised a global bond benchmark that weights countries according to their gross domestic product. The idea is to put more money into bonds from borrowers that have the greatest national income, not the most debt.Because Japan accounts for about 9% of global GDP, that is the country's weighting in the Pimco Global Advantage Government Bond Index. In contrast, Japan -- which has huge debts -- accounts for 30% of the Citigroup World Government Bond Index, a traditional benchmark weighted by market capitalization. Emerging markets account for 30% of the Pimco index, compared with a figure of 1% for the Citigroup benchmark. Pimco says that over the past 20 years, a GDP-weighted index would have outdone a traditional benchmark by about a third of a percentage point annually. But the advantage could be greater in the future as emerging markets account for a growing share of world GDP. To appreciate why bonds of fast-growing emerging markets could outdo issues from the developed world, compare markets in Japan and Brazil. At a time Japan's economy seems trapped in sluggish growth, the country's bonds yield a meager 1.5%. In contrast, bonds in growing Brazil yield 12%. The yield must be higher to compensate investors for the risk of inflation. In addition, the currency of the fast-growing economy is likely to appreciate against the sluggish yen, which would boost returns for foreign bond holders.