In a landmark development for bond markets, iBoxx has recently launched a family of liquid bond indices. These indices are designed for bond investors who wish to restrict their investments to only the most liquid of fixed-income instruments, without necessarily limiting themselves to sovereign credits.
Demand for liquid indices has always existed, but that demand has been increasing over recent years as investors have realised that bond market liquidity is always a matter of degree and in any case cannot always be taken for granted. The immediate aftermath of the LTCM collapse provided markets with an awesome demonstration of how quickly liquidity can evaporate, even for bonds that have long been considered to be paragons of liquidity.
In the days following the LTCM rescue operation, off-the-run US Treasuries became difficult to sell or even to repo, except on unacceptable terms. This traumatic experience spurred market participants to focus more closely on aspects of bond market liquidity, but until now, no one has seriously attempted to calibrate a bond market index specifically geared to maximise its overall liquidity.
There are numerous reasons why. Unlike equities, bonds tend to move all in the same direction at any given time, and that movement is essentially driven by changes in interest rates. Hence, ascertaining the general direction and amplitude of market movements is a relatively simple affair. But precise measures are far more problematic:
o there are very many more bonds outstanding than shares;
o bonds do not trade on an open exchange; and
o there are few centralised sources of information on even the basic descriptive details of the terms and conditions of bonds, let alone their individual price movements.
And because bonds are not traded on an exchange, there is no easy way to determine the turnover of any specific issue over any specific time period. In particular, it is currently impossible to determine bond turnover in real time – or even afterwards – not least because the holders of the information, the clearing houses are very adverse to revealing it.
The iBoxx solution to the problems of calculating a liquid index is both elegant and simple. The criteria for bond inclusion address specific liquidity aspects of individual bonds, while an overall limit on the number of issues protects the indices from becoming unwieldy behemoths. Thus, the overall corporate index will only include those 40 largest bonds from different investment-grade issuers, that have at least 18 months of remaining life, and have been outstanding for no more than two years. Sub-indices will include fewer bonds: either 20 or 15, depending on the sector covered. In addition the minimum amount outstanding must be at least E1bn. The combination of these criteria not only addresses pure liquidity questions, such as issue size and issue age, but also maximises the diversification effect by insisting on 40 different issuers. This latter point is particularly important when investing in corporate bonds. The incentive to invest in corporates is the incremental return that they provide, but that incremental return comes at the cost of additional risk, which is best mitigated by a strict policy of diversification. As a result, the iBoxx inclusion criteria for liquid indices strike an optimal balance by minimising the risk associated with corporate bonds through diversification, while maintaining the necessary criteria to maximise liquidity: size and age.
The main source of demand for liquid indices stems from fund managers looking to offer higher returns than those available from money-markets or short-term government bonds. For these managers the only liquid non-government benchmark available has been LIBOR/EURIBOR in Europe or prime rate in the US. Both of these measures are bank-driven, and the former explicitly encompasses bank credit risk. Moreover, both measures are essentially short-term and are really only appropriate for investors who absolutely need to preserve capital. In an interest-rate environment that is at historically low levels, the search for low-risk incremental return has become more urgent, and the trade off between capital preservation and additional return has become more flexible. Increasingly, investors are willing to take some capital risk in exchange for higher returns, but only if they can be confident that their investments can be converted to cash instantly. Hence the search for a suitably liquid benchmark, and why iBoxx has designed this solution.
iBoxx also publishes liquid indices for sovereign issuers. The inclusion criteria for these are slightly different to those for the corporate indices: the minimum issue size is larger (E2bn), and the maximum issue age is four years rather than two year for corporates. Since government bonds are frequently used to hedge with, their liquidity tends to be less affected by the passage of time. As interest rates are the dominant determinants for government bond prices, the emphasis of the sovereign liquid indices lies more in the exposure to yield curve differences through different maturity segments rather than the overall market. Three different maturity bands are published, and each of these is limited to the 10 largest and most recently issued bonds. Obviously, in the case of sovereign issuers there is less need to diversify, and consequently a limit on the number of bonds that can be included from a single issuer is unnecessary.
iBoxx is positioned to calculate and publish liquid indices, for it is the only index provider that not only consolidates prices from multiple price providers, but does so throughout the trading day in regular intervals – an index published once a day could hardly be categorised as “liquid”.
Index prices are calculated every minute of the trading day by Deutsche Boerse, the bond quotes being provided by ABN AMRO, Barclays Capital, BNP Paribas, Deutsche Bank, Dresdner Kleinwort Wasserstein, Morgan Stanley and UBS Warburg. The combination of authoritative pricing and frequent publication makes the iBoxx liquid indices the most efficient and accurate benchmarks available to anyone running funds that put a high premium on liquidity but require an investible universe that stretches beyond mere short-term government and bank paper. The pitfalls of creating such a family of indices are well-known, and have proved too daunting for traditional proprietary index providers. It is apparent that no single price provider could ever guarantee the level of price accuracy required by a liquid index, and that a price discovery process from multiple sources such as the one adopted by iBoxx is a necessary prerequisite of such an index. Furthermore, in order to reflect the value of liquid bonds, it also needs to be published in real time with a high frequency. iBoxx has the superstructure of seven premier price-providers and the infrastructure of a stock exchange, which together allow for the timely and accurate calculation and publication of this index family.
David Mark is chief executive of iBoxx in Frankfurt
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