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Pimco Has New Way of Looking at World

The fund manager finds that GDP is a better measure of a country's bond performance.

NEW YORK (TheStreet) -- If you buy Vanguard Total Bond Market Index (VBMFX) - Get Vanguard Bond Index Fund Total Bond Market Index Fd Report, you have a big stake in Treasuries and tiny holdings in debt from such blue-chip corporate issuers as International Business Machines (IBM) - Get International Business Machines Corporation Report and Wal-Mart Stores (WMT) - Get Walmart Inc. Report.

The Vanguard portfolio, which tracks the

Barclays Capital Aggregate Bond


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


, 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.

"The total returns should be higher in the dynamic economies because of currency appreciation and higher yields," Toloui says.

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, an actively managed mutual fund that aims to outdo Pimco's new global benchmark. Toloui serves as portfolio manager, and he has the ability to overweight sectors when they seem attractive.

Lately the fund has turned defensive. Toloui fears that ongoing debt problems will hold back the economies in the U.S. and Europe. That will put a damper on corporate bonds, which would be hurt if earnings prove more sluggish than investors expect. To avoid trouble, he is underweighting corporate bonds and emphasizing U.S. Treasuries, which tend to hold their value when the economy is weak.

"In light of the continuing problems of the U.S. economy, it seems that investors have been excessively optimistic about corporate bonds," he says.

The Pimco fund takes positions in currencies. Toloui is currently overweight currencies from Brazil and other emerging markets. He is underweighting the euro, which could suffer more weakness as Greece and other countries struggle with debt problems.

During the past 12 months, the fund returned 7.4%, lagging 57% of competitors in the world bond category, according to Morningstar. Toloui's emphasis on government bonds hurt in a year when low-quality corporate bonds rebounded sharply from depressed levels. But if PIMCO's gloomy forecast proves correct, the fund should top competitors and outdo the new global benchmark.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.