Felix Goltz, Head of applied research, EDHEC-Risk Institute
EDHEC-Risk Institute conducted a study on corporate bond indices in 2011 to analyse construction methodologies, risk and return properties, and the stability of their risk exposures. Subsequently, EDHEC-Risk Institute organised a ‘call for reaction’ in which it asked investment professionals to give their reactions to the research. Here, we report on the results.
As investors have had concerns about the ability of euro-zone governments to solve the sovereign crisis and look for higher yields, corporate bonds have started to be seen as a substitute when it comes to creating low risk portfolios and many investors have increased their corporate bond exposure.
A Fitch survey of European fixed-income investors reports that, in 2011, a majority of fixed-income investors had reallocated their cash to corporate bonds, with a total outflow from euro sovereign bond funds of €33bn. In the context of the recent financial crisis, resulting in a loss of confidence in government bonds, high-grade corporate bonds appear as an alternative to sovereign debt. Bill Gross of PIMCO noted in 2010 that corporate debt was “now looking safer” than some sovereign debt.
Also, record high corporate bond fund inflows were reported by John Melloy in February 2012. Steiner notes that investment grade bonds “have shorter maturities than sovereigns. If interest rates rose, the book losses would be significantly lower”. International Financial Reporting Standards (IFRS) recommend using a discount rate determined by reference to market yield on high quality corporate bonds (IAS 19.78), preferably to the market yields on government bonds, to determine the present value of pension obligations.
The use of indices for corporate bond investments is starting to become broader, strengthened by the proliferation of fixed-income ETFs which allow access to direct index portfolio strategies. However, given how established corporate bonds are as an asset class, it is surprising that little progress has been made in corporate bond indexing, where indices typically follow a standard debt-weighting scheme. This is in contrast with the world of equity indices, where various styles and construction methodologies are being developed.
It is important to analyse how corporate bond index construction deals with the main risk factor exposures for investors in the corporate bond universe. Corporate bond returns are affected by factors such as interest rates, as well as issuer-specific factors, including credit-worthiness. The latter risk factor has prompted an industry of credit rating agencies to emerge, facilitating the standardisation of credit appraisal.
Further, the corporate bond market has a structure entirely different from that of equities, with dealer-facilitated trading and low volume, leading to wide bid-ask spreads, opaque pricing, and illiquidity (cf. Biais et al., 2006; Dick-Nielsen et al., 2012). These risk factors and their importance and behaviour in the context of indices were examined in an EDHEC-Risk Institute paper (Goltz and Campani, 2011). The study found unstable risk exposure, and highly unstable duration, across eight indices, in the euro-zone and the US, and with heightened instability in two so-called ‘investable’ indices.
The explanation provided in this study for the increasing risk exposure was that screening bonds for liquidity to come up with indices that include relatively few liquid bonds will inevitably lead to higher instability. In the end, investors are faced with a trade-off of having either broad corporate bond indices which are illiquid and have moderate instability of risk factor exposures or using liquid indices which will suffer from more pronounced instability in risk factor exposures.
In addition, Goltz and Campani (2011) underlined the conflicting interest in the duration of corporate bonds between bond issuers and investors, described in the literature by Siegel (2003), and known as the duration problem. The duration structure of outstanding bonds reflects the issuers’ preference for minimising their cost of capital. In contrast, the investors’ interests are to maximise their returns. There is no reason, in principle, for these two objectives to be aligned.
Credit risk exposure was also identified by Goltz and Campani (2011) as largely unstable. The fluctuations in corporate bond index risk exposures seem to indicate that current corporate bond indices are inappropriate for many investors who seek stable exposures to keep their allocation decisions from being compromised by fluctuations.
To supplement the results of the EDHEC-Risk Institute paper, a call for reaction was issued to gather evidence on investor perceptions of the issues related to corporate bond indexing. A questionnaire, covering in detail the various issue points, was proposed to investment professionals. 68 responses were received, including respondents from North America (40%), the European Union excluding the UK (26%), the UK (17%), Switzerland (8%), and Australia and New Zealand (9%), thus constituting a diversified sample of investors. The population of respondents was made up mostly of asset/wealth managers (74%). The conclusion was that the respondents were in agreement with the criticism raised by Goltz and Campani (2011).
First, it appears that only 41% of respondents are satisfied or very satisfied with corporate bond indices, which confirms the inadequacy of corporate bond indices with respect to investors’ needs described by Goltz and Campani (2011). The responses reveal that several issues are seen as paramount to investors in corporate bonds and corporate bond indices. The instability of corporate bond indices’ risk factor exposures, arguably the key conclusion of the underlying paper, was affirmed by the majority of respondents.
For example, between 64% and 80% of respondents agree, or strongly agreed, that the instability of interest rate risk exposure is problematic. In addition, 45% of respondents agreed, or strongly agreed, that bond issuers and investors have conflicting interests when it comes to duration. Using derivatives may appear as a solution to interest rate risk instability as in principle one can create on overlay strategy that neutralises the fluctuation of risk exposures in the underlying index. However, only 57% of respondents indicated they can use derivatives for such purposes, leaving almost half of them with no tools to manage instability.
The instability of exposure to credit risk is also identified as problematic by about two-thirds of respondents.
Furthermore, nearly half of respondents recognise that there is a direct trade-off between an index’s risk factor stability and its investability, which will probably present obstacles to index providers who wish to provide indices that are created to be the foundation of an investment vehicle. The various issues identified may explain the current relative unpopularity of passive investing in corporate bonds. As corporate bond indices should allow investors to achieve specific objectives, particularly to manage defined risk factors, it will be important for index providers to construct indices using methods that account for the stability of these risk factors.
Literature references can be found at www.edhec-risk.com. The study from which this article was drawn can be found at bit.ly/Z2vpBJ