By Colin Barr
August 30, 2010

It’s only a matter of time till runaway debtors such as the United States hit the wall, investor Rob Arnott argues.

Arnott, who runs the value-focused Research Affiliates investment manager in Newport Beach, Calif., writes in his monthly newsletter that it’s imperative that bond investors diversify away from debt-soaked rich countries such as the United States.

The reminder comes at a time when the latest flight to safety is on. Investors have been pouring funds into bonds issued by big governments, driving yields down to levels seen previously only in the depth of the 2008 financial crisis.

But Arnott joins the chorus of voices questioning that choice. Looking strictly at nonpolitical factors, Arnott contends that the best bets for bondholders lie in faster-growing developing countries and in more prudent developed countries, such as Australia and Canada. The biggest debt issuers, he continues, are the biggest, most underappreciated risk of all.

One might reasonably argue that—absent political risk—emerging markets are collectively more creditworthy than U.S. Treasuries. Which invites a provocative question: when will U.S. Treasuries be priced to offer a “risk premium” (higher yield) more than the most stable and solvent sovereign debt that money can buy: Emerging Markets?

The action in the markets this year suggests the answer is no time soon. But Arnott says it’s time to confront the problem before it becomes acute.

The issue, Arnott says, is that sovereign debt investors have much more exposure to the five richest countries – the United States, Japan, Germany, France and the United Kingdom – than is justified by those nations’ economic output, population or share of global resources.

The so-called G-5 nations account for 68% of global sovereign debt outstanding, Arnott indicates. That’s almost three times the weight they should carry, according to a Research Affiliates estimate.

Meanwhile, emerging markets account for just over 10% of debt issued but should command a 58% share of investors’ wallets, based on Research Affiliates’ assessment of their economic, demographic and resource data.

Let’s consider the rest of the emerging markets list. Not one of the other 43 emerging markets, which spans all countries that are included in any of the EM debt indexes, has as much debt as any of the G–5 countries, whether measured relative to GDP or relative to the RAFI fundamental economic footprint of these countries. In almost all cases, emerging markets debt is modest relative to their respective ability to carry debt based on the four factors of economic production.

If that’s not enough, he contends the debt problems in the stressed European countries known as the PIIGS, for Portugal, Ireland, Italy, Greece and Spain, aren’t markedly worse on this basis than in the rest of the developed world. We are all pigs, if not PIIGS, is the message.

Arnott then invokes a 1980s vintage seatbelt ad to warn that the past decade shows too few people learn the appropriate lessons till it’s too late.

But have we learned the proper restraints in our investment portfolios from our two most recent debt crash dummies—Greece and the U.S. homeowner? Doubtful. Let’s take a close look at our bond allocations and the index funds that comprise them. The wall is coming. Are we buckled up?

It seems we aren’t.

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