The makings of good indices
With the rise in corporate bond issuance, the advent of the euro and three years of declining equity markets, investors in Europe have altered the way they look at fixed income instruments. And as their behaviour has changed, so too has the range of bond indices available, as index providers attempt to meet changing demands.
“It’s really quite amazing the change that’s happened in fixed income benchmarks,” says James Martielli, director of global fixed income at SEI Investments in London. Up to around three years ago, the common benchmark for fixed income in the UK was the CAPS Median, he says.
But since then UK institutional investors have moved very quickly to a market benchmark. Now, aggregate portfolios have become more acceptable, containing a mix of corporate and government bonds.
The most widely used fixed income indices, for European institutions, are the Merrill Lynch and the Lehman Brothers bond indices. MSCI also runs a large family of investment grade euro credit indices, and it has plans to roll out a series of US domestic indices.
Frankfurt-based provider iBoxx has a wide range of fixed income indices, and Goldman Sachs runs a family of global credit indices.
In the last quarter of 2002, the traditional equities index provider, FTSE made a further step into the bond indices marketplace, buying the Bondtop indices from Reuters. Reuters is continuing to distribute the indices, but they will be rebranded as the FTSE Global Bond Index series.
Over the last few years, there has been much more interest in corporate bonds on the institutional level, says Carl Beckley, director of research and development at FTSE Group. Although FTSE has calculated the UK Gilt indices since inception, it is best known for its equity indices. Beckley says the provider is now complementing its existing equities indices with these new bond indices, extending its cover to both of the major asset classes that exist – stocks and bonds.
Any bond index now needs good technological back-up to keep users happy. Technology is an area that Merrill Lynch has been particularly successful in, industry participants say. Through their link to Bloomberg, detailed data from their fixed income indices can be obtained instantly.
The Lehman Brothers indices are very well established and in the US where 90% of fixed income is benchmarked against them. However, the indices have been criticised for not being particularly user-friendly.
In the past half-decade there has been a significant increase in bond issuance by European corporates, says Andrew Wilson, managing director and co-head of the global fixed income and currency team at Goldman Sachs Asset Management.
Also, some of the big US issuers started taking advantage of the European market. In terms of fixed income indices, this development has meant a move away from pure government bond indices towards a blend of governments and corporates, says Wilson.
He says both corporate and government debt should be included in an index as this gives a more complete representation of the universe. In Europe, about 38% of the bond market is now non-government, while in the US the proportions are weighted the other way, with the government component smaller than the corporate.
“You should include both government and corporate to get as full a representation as possible,” he says. “If you have a government-only benchmark, you can be long corporates but never underweight them. It gives you the flexibility to add value in all kinds of credit environments.”
But needs vary, and so the right mix of governments and corporates can often only be achieved by customising an index. In the UK, as opposed to the continental Europe, there is a much higher degree of customisation of fixed income benchmarks, says Martielli. “There’s really no standard benchmark, just a whole variety of slices and dices. On the continent there seems to be more emphasis on the aggregate.”
Deciding which benchmark to use is crucial with respect to its maturity and proportion of credit. “Making that benchmark decision can be just as important as picking the right manager,” he says.
While needs may be changing for bond indices, newcomers often have trouble getting established in the fixed income index marketplace. Investors can be reluctant to switch to a recently introduced index, even if it does have some smoother features, because they are unsure how long the benchmark will be calculated for.
But starting up a new series of indices can have its advantages, says Nigel Cresswell, vice president at MSCI in Frankfurt. Though the market leader internationally in equity benchmarks, MSCI is a relative newcomer to fixed income benchmarks, bringing out its first bond indices in 1995. “We were able to take a new approach. We had no legacy methodology and no legacy software which is something that should not be underestimated in our business.” It meant MSCI was able to take account of new needs in the fixed income investment marketplace. Firstly, the provider was able to use real bond prices, rather than matrix prices, from the outset. “All our bonds are trader-priced, which make the index investable.”
Also, MSCI was able to start afresh with classifications. It uses the same sector classification system for its bonds as it does for equities. Some traditional bond classifications are quite archaic and no longer helpful in terms of risk profile, says Cresswell, giving as an example telecommunications issuers, which are in some cases still classified as utilities.
Since there is an increased need for customisation of indices, MSCI’s recent start has given the provider an edge here too. The new technology and tools are available to make customised indices very quickly.
What are the most important characteristics of a good bond index? Critical factors for a successful fixed income index are transparency and technological support, says Wilson of Goldmans. Transparency is important because users have to be clear about which issues will be included, so that there are no surprises. Secondly, users of an index need support in terms of analytics, so that they can break the index down by corporate sector and also to understand what is driving performance.
Martielli says the key requirements of a fixed income index are acceptability, access to data, comprehensiveness and longevity – he needs to be confident it will still be around in a few years from now. In terms of liquidity, Martielli says SEI prefers an index that is more comprehensive. “Ideally you want an index that is liquid and therefore investable, but there’s a constant tug between what’s liquid and what’s comprehensive.”
If an index is particularly liquid there is a danger that it is not capturing the true investment opportunities, and also that it is not diversified enough.
Liquidity, says Denis Gould, head of fixed income investments at Axa Investment Managers, is much more difficult to see in bond markets than in equity markets. This is why the efficient delivery of this information by index providers is very important.
Gould points out that iBoxx has multiple price data from seven price sources. iBoxx’s David Mark in Frankfurt has said that demand for liquid indices has always existed, but that this demand has increased over recent years. This happened when investors realised that bond market liquidity is always a matter of degree and cannot be taken for granted.
Merrill Lynch launched a new series of bond indices late last year that aimed at limiting exposure to any one issuer. The High Yield Issuer Constrained Index series places a 2% cap on the allocation to any one issuer. Explaining the rationale for the launch, the provider said that the large influx of heavily debt-laden ‘fallen angels’ had significantly altered the high-yield landscape.