Ready for a shake-out
In the world of equities, much of the complexity of risk assessment and management has been simplified through the development of capitalisation-weighted indices and the spectacular growth of indexed funds on the back of this. At first sight, it appears a straightforward extension to apply the same approach to the management of fixed interest assets. Indeed, there has been a proliferation of bond indices produced by newspapers, brokers and exchanges, competing for attention. There are however, many differences in both the philosophical under-pinnings of bond indices as well as their practical implementation that make them very different animals to deal with.
Constructing bond indices that satisfy all of the people, all of the time, is clearly impossible, but satisfying most of the people most of the time has also proved to be more difficult than has been the case for the equity markets. There are good reasons why this is so. Key issues include; the nature of the passive investment decision inherent in the construction of an index; the sourcing of accurate pricing; the trade-off between coverage and investability in the index; the stability of the index; and the extent to which the data available can be used to tailor individual benchmarks for performance and attribution.
Indexing and portfolio construction
Any bond investor is essentially trying to avoid overvalued bonds where the risk of default far outweighs the extra yield. A well structured bond portfolio should be diversified across a range of credits with no undue concentration in sectors or issuers. A fundamental difference between equities and debt indices is that the amount of an issuer’s debt represented in a bond index is not very sensitive to the market’s pricing of its debt. The credit spread forms only a small part of a bond’s yield except for high yield or distressed debt portfolios. As a result, we have the perverse result that the weaker an entity becomes financially through the issuance of more debt, the more an index will weight that entity, even though its attractiveness is reduced. In contrast, unsuccessful companies with decreasing equity prices will see their weightings automatically decrease in a capitalisation weighted equity index.
Accurate pricing is a major issue in the bond markets. Unlike equities, there is no single exchange price that can be utilised as the current or closing price for a bond. This is exacerbated by the sheer number of different issues with the total number of fixed interest securities a large multiple of the total number of equities. A large proportion of issuance is not traded at all, and a study of the universe of around 10,000 bonds priced by ISMA members by one fund manager found that at any given point in time at least 2,000 of these prices can be defined as stale (ie, no new traded price for over a day). In the US, the SEC’s requirements for accurate pricing to protect investors have led many bond managers to use evaluated or “fair value” pricing to value their portfolios. These are prices calculated by third parties such as S&P and FTSE that revalue bonds on a daily basis using publicly available information.
The sourcing of prices for valuations of portfolios is often critically dependent on the benchmark chosen for performance evaluation. Bond managers face the issue that the valuation of their portfolios may use different price feeds from that used by the benchmark index providers, which will introduce a tracking error to their relative performance figures. Given that bond outperformance targets may be as little as 50bp above the index, this tracking error can be significant relative to the target outperformance. Some index funds as well as some active managers eliminate this source of tracking error by using the index providers to obtain prices for bonds in portfolios measured against that index. The advantage of this is that the index price can be very inaccurate but would not affect the relative performance of the fund against the index. The onus is then on the index providers to ensure their prices are accurate.
Given that price sourcing is one of the most critical issues when it comes to indices, a clear distinction can be drawn between those indices produced by investment banks using their own prices as the only source, and indices that obtain prices from a number of independent sources. The world of bond indices used to be dominated by market-makers’ own indices with prices sourced only from their own desks The major alternatives to this were the FTSE Global Bond Index Series (formerly Reuters BONDTOP) using market makers prices on Reuters and the Bloomberg government bond indices based on their generic prices. In the last couple of years, two new sets of indices, iBoxx and EuroMTS, have been introduced and have attracted a great deal of attention as they both address the issue of price sourcing from multiple providers in an effective although not perfect manner.
The EuroMTS indices currently only cover euro-denominated government bonds, but the prices are obtained from more than 250 independent inter-bank participants quoting on the MTS electronic platform and represent a large proportion of total turnover. The prices used are live prices that can be dealt at according to EuroMTS, and from a very strong coverage in the French market, they are targeting the rest of the Euro-zone.
iBoxx produces government, corporate and collateralised bond prices from a consortium of around seven market makers and is rapidly attracting interest from fund managers. The problem with iBoxx indices is that whilst the consortium market makers may be the best in certain sectors, they are not for everything so attempting to undertake performance attribution on sectors may be unreliable using the indices, a problem that would not exist for equity indices using exchange prices. In addition, many of the prices quoted are only ‘matrix prices’ produced using standard assumptions on spreads and so dealing prices could be different from the index prices although the problems are much less than for indices with single price sources.
Trade-off between coverage and investability
A large percentage of the total market is rarely traded and index providers are faced with the choice of coverage versus invest? liquidity. Very liquid indices with a narrow coverage are attractive from an index-providers viewpoint since they can form the basis of highly lucrative derivative products. However, a bond fund manager needs to access the whole market and his performance needs to be measured against that objective and risks controlled relative to the total market. This is a difficult conundrum to solve. The Lehman’s bond indices which are very popular in the US have gone for wide coverage but as a result, are not easily investable so to what extent are they a measure of performance? Lehman Brothers Euro-Aggregate Index initially had nearly 7,000 bonds and after raising the minimum size, it still has 2,000.
EuroMTS attempt to finesse the problem of coverage verse investability by concentrating on liquid stocks in each maturity bond with a maximum of two from each country weighted according to the relative size of the debt market. Whilst this produces a liquid index well suited for arbitraging derivative products, it clearly does not cover the markets very broadly. There is also an argument that says that individual credits within the Euro-zone are not necessarily equal and therefore should be able to be separated.
The structure of bond indices divided by maturity, credit rating and currency can give rise to high turnover. Whilst currency does not change (at least not often), bonds all mature and fall out of each sub-index on a predictable basis whilst new issuance also gives rise to instability. To reduce these effects, index providers either have to subjectively choose a basket of securities to represent the broad market, as EuroMTS have done, which means a relatively small number of issues and a high specific risk, or they have to use a rules based approach that includes all securities that fall within defined constraints. Such an approach can also give rise to problems. Corporate high yield indices suffer from the effect of “fallen angels”, for example, debt from large high rated companies that suffer a downgrade take up a disproportionate amount of an index and fund managers are left with the choice of either having an excessive absolute exposure to the company (possibly breaching fund guidelines), or face the risk of underperforming the index if the ratings improve.
Bonds are often used to match liabilities. Using one-size fits all index approach to produce a performance benchmark sets the wrong parameters for a bond manager. The risk of not matching liabilities is not measured and replaced instead, by measuring very precisely, the risk of not beating a benchmark index that has little relevance to the business objectives of the investment. Users of Bloomberg and FTSE’s indices can combine the index subcomponents easily and utilise a variety of analytical techniques based on the data. EuroMTS are at an early stage in the development of such capabilities but have the ability to supply data for separate analysis easily.
Where to next?
Competition amongst index providers is clearly increasing with the new players on the market. An ideal index series would have the following characteristics:
o obtains prices from as wide a marketplace as possible;
o have a broad coverage to be useful for performance attribution;
o probably have a component that is narrower focussing on more liquid bonds only for use in derivative products;
o be combined with analytical capabilities to be able to construct zero, par and forward yield curves;
o be able to combine sub-indices for government bonds, corporate bonds, emerging market debt and asset backed securities and other structured products in a consistent manner.
So far, FTSE, Bloomberg, iBoxx and EuroMTS can claim to have multiple price sources. The long established broker indices ultimately all face the problem of their price sourcing. The iBoxx approach has attracted large interest in a short space of time. It still only uses prices from only seven or so market-makers and if this was increased to a much larger number, it could become a dominant player.
The EuroMTS approach has the fundamental requirement of being able to source prices from probably as wide a market as is possible although covering only Euro-zone government bonds. However, the indices themselves need to be expanded in scope, with broader coverage, split into individual countries and with analytics capabilities added in some form.
Whilst government bonds, corporate bonds and emerging market debt are at least straightforward conceptually, asset backed securities and other structured instruments such as CDOs are very complex, very illiquid and often have only one market maker giving prices. Producing indices for these markets may require the use of evaluated prices which, whilst having the disadvantage of not being directly tradeable by market-makers, will help make these asset classes more attractive investments with independent valuations and benchmarks available.
The bets are still on as to which provider will dominate the market in the years to come, but one thing is clear, the current plethora of players will narrow down and the future will belong to those able to offer prices from multiple market-makers which favours those with strong partnerships with data vendors and electronic exchanges.