As the range of opportunities in the global fixed income market expands, the benchmark indices against which investment performance is measured must be re-examined. The complexion of the market, historically dominated by sovereign debt, is changing with increased issuance from non-sovereign entities including private corporations and collateralised lenders. In fact, non-government bonds now account for more than 50% of outstanding global bond issuance (see figure 1).
Allocations to these growing sectors are prudent for long-term investors such as insurance companies and pension funds, as they provide the potential for higher total returns over time while greatly enhancing diversification within a fixed-income portfolio.
Investors and consultants need appropriate benchmark indices to gauge manager style and performance as portfolio managers commit larger and larger allocations to these sectors and away from government markets. In this article, we take a look at some of the new global bond indices emerging in the investment community and touch on some of the issues that should be addressed when contemplating a switch to a multi-currency, multi-sector benchmark index.
Several investment banking firms now compile and publish information on multi-currency indices that include all issues that meet certain minimum size, credit, and liquidity standards set by the respective firm. The most widely accepted of these indices include the Lehman Brothers Global Aggregate Index, the Salomon Brothers World Broad Investment Grade Bond Index and the Merrill Lynch Global Broad Market Index (see figure 2).
While composition differs among these three indices due to the minimum issue size of corporate and collateral bonds included, they all allow only investment grade debt and have an average duration of around five years. The US portion accounts for nearly half of each index, with Euro-land and Japan representing roughly 25% and 15%, respectively. With a 5% allocation to the UK, these indices have about 95% of constituent securities in the world’s four major bond markets. Government debt represents approximately half of each index, with the bulk of the remaining constituents classified as quasi-government, corporate, or mortgage-backed securities.

Issue 1: greater diversification
For the past 15 years, global bond investing has focused on local-currency government yield curves around the world. As a result two government-only indices have dominated the asset class: the Salomon Brothers World Government Bond Index and the JP Morgan Government Bond Index. Both indices include local currency bonds issued by investment grade countries with a sufficient amount of liquid issuance to be considered a developed market.
Bonds are valued based on the local interest rates corresponding to the currency of denomination. Therefore, a portfolio invested across several countries (denominated in several currencies) diversifies the investor’s assets away from a single domestic market. Prior to the introduction of the euro, a global government bond investor typically had exposure to at least 12 different interest rate markets whose bond returns were not highly correlated.
Over the past five years, however, we have witnessed a convergence of monetary policy, fiscal policy, economic cycles and, consequently, bond yields in many of the world’s developed markets. In Europe this process was a formal one, necessary to adopt a common currency. Within the dollar-bloc markets of the US, Canada, and Australia this has also taken place, albeit, to a lesser degree. Potential diversification has therefore been reduced by two-thirds as the global government bond market is left with only four distinct regional markets: Euroland, dollar-bloc, UK and Japan.
These market movements have effectively eliminated much of the return and diversification possibilities for investors and their asset managers. Thus global aggregate indices enter the picture. These indices include bonds from up to 30 different countries denominated in over 20 currencies. Furthermore, each of the major country components can be divided into four broad sectors: government, agency/supranational, corporate, and collateralised/mortgage (see figure 3).
This expanded universe has exposure to 2,000 distinct issuers, up from 19 in a traditional government-only portfolio. Clearly, this type of investment strategy is far more diversified.

Issue 2: too much diversification?
Is diversification for its own sake always desirable? In the end do investors have exposure to the markets they want? We have found that many investors contemplating these indices do not fully appreciate the degree to which they will be invested in markets they know little about. In addition to the expected sectors such as global corporate and agency debt, the investor also becomes active in US mortgages, German Pfandbriefe, asset-backed securities and an assortment of other sectors. Additional countries, which many consider ‘emerging markets’ also come into play, including Mexico, Chile, Poland, Hungary, South Korea, China, Malaysia, Israel, Qatar, and South Africa. Keep in mind that in our index-focused world the manager must be invested in these markets just to be neutral; otherwise, they are making a bet versus the index.
For the investor coming from a domestic-market perspective, the currency exposure must also be carefully considered. Unhedged currency exposure dramatically alters the risk profile of the portfolio, in many ways undermining the ‘fixed-income’ nature of the investment. This should not preclude an investor however, as hedging currency exposure using forwards is efficient and relatively low cost. The manager must simply take into account the economic impact of the hedge when making a country allocation shift.

Issue 3: ability to underweight sectors
In the traditional global mandate the strategies managers use to outperform government benchmarks include being overweight or underweight specific countries, shortening or lengthening duration, or making duration-neutral curve bets. They may also have the ability to use out-of-index strategies such as investing in agency or corporate debt. However, the risks associated with these strategies are asymmetric due to the inability of the manager to underweight an out-of-index sector versus a global government index. Managing and reporting results relative to a multi-sectored index gives the manager the ability to generate alpha in all market environments, and gives the evaluator the information necessary to evaluate which managers are skilled in these markets.

Issue 4: enough corporates?
The global corporate bond market has grown at a remarkable rate over the past three years. The introduction of the euro in January 1999 has fueled growth in European corporate bond issuance, allowing issuers and investors to transact through the single currency. Issuance in the sterling corporate market continues to gain momentum as pension fund reform has shifted demand toward higher yielding bonds. The euro corporate market has grown 125% since 1999 and the sterling corporate market has grown by 69% over the same period (see figure 4).
These new global indices provide opportunities for traditional global investors to expand into credit, and domestic ‘core’ investors to expand into the global environment. However, both sets of investors might find their credit allocations smaller than anticipated. Corporate bonds comprise only 15% of the Lehman Global Aggregate Index, with sterling and euro-denominated corporates less than 4%.

The shift is under way
As portfolio managers our job is to find the optimal mix of investments that produce high total returns over time with a limited amount of risk. The more tools (or bonds) we have in our opportunity set the better equipped we are to diversify interest rate and issuer risk while identifying undervalued markets and sectors. In spite of the issues that must be addressed when contemplating a benchmark change, those of us involved in the management of global fixed-income assets know it is time to tackle those challenges in order to benefit from the full range of securities now available.
Laura Zimmerman is managing principal at Payden & Rygel in Los Angeles