Investment bank Citi and fundamental indexing specialist Research Affiliates have launched a global investment-grade corporate bond index in a pioneering move to extend the smart-beta concept further into the fixed income world.
The Citi RAFI World Corporate Investment-Grade Bond index uses two factors in weighting bonds in the portfolio: long-term assets, which represents the portion of assets that long-term bondholders have a claim on, and cash flow, which reflects debt service capacity.
In addition, financial ratios are used to reduce exposure to companies that are more susceptible to downgrades.
The index values are calculated and published by Citi using this fundamental indexing methodology developed by Research Affiliates.
The methodology significantly reduces the new index’s debt-to-equity ratio relative to that of the market capitalisation-weighted Merrill Lynch Global Corporate Bond index benchmark, from 0.83 to 0.73.
The debt-to-cash flow ratio is reduced from 9.78 to 6.47.
Rob Arnott, chief executive at Research Affiliates, said: “Traditional bond indices, which give the largest weights to the biggest debtors, are great tools for benchmarking performance but they are suboptimal as the basis for investment funds. There is a better way to construct bond indices for investment purposes.”
The firm’s research suggests that, between 1997 and 2013, issuers with higher leverage did trade with higher average spreads, but the relationship was far from linear.
Moreover, volatility of annualised total returns increased with higher leverage but annualised total returns did not, suggesting investors are not compensated for the extra risk.
Similar results were returned when the firm looked at levels of debt coverage.
Looking at the ratios of working capital, cash flow, sales and leverage to assets – which academic research indicate are predictive of downgrade risk – Research Affiliates found that the 3% of issuers excluded from the index on the basis of these ratios returned 4.1% with 9.4% volatility, versus 6.4% with 6.2% volatility from the rest of the universe.
Shane Shepherd, senior vice-president and head of fixed income research for Research Affiliates, said: “Our research reveals that investors’ reach for yield is often not properly compensated.
“This new index offers lower credit risk, lower volatility and better risk-adjusted returns over full market cycles than traditional market value-weighted indices.”
The Citi RAFI index’s excess risk-adjusted return does not appear to result from exchanging credit risk for duration or currency risk.
Currency exposures are almost identical with the market portfolio’s, and the index is only slightly overweight in the 3-10 year part of the curve, and underweight at both the short and the very long end.
Most of the active weight in credit rating is located in the AA and single-A part of the spectrum: the RAFI index is about 3 percentage points overweight in AA paper, 1.8 percentage points underweight single-A and 1.5 percentage points underweight BBB.
There are some meaningful sector active weights: 9.5 percentage points overweight industrials, 3.2 percentage points underweight utilities and 5.3 percentage points underweight financials.
Research Affiliates acknowledges that its methodology of measuring average annual cash flow smoothed over five years does not capture the relative stability of those cash flows, which might affect the relative riskiness of similar levels of balance-sheet debt held by companies in different sectors.
The Citi RAFI index has a turnover of 43%, versus that of 26% from the Merrill Lynch index, while the weighted average bid/ask spread is 1 basis point higher than the cap-weighted index’s, at 0.28%.
That would result in a 4-5 basis point excess cost, before other fees associated with investable products built on the index.
More than $118bn (€86bn) is managed against Research Affiliates’ fundamental indexing equity indices.
This new product joins fundamental indices for sovereign developed markets and sovereign emerging markets local currency debt in the Citi RAFI Bonds Index Series.
Helge Kostka, a vice-president in European business development for Research Affiliates, said: “In some respects, one might expect that the smart-beta ideas would be best-suited to fixed income, but while there have been some index products launched in sovereign bonds, very little seems to have been done in credit.”
Speaking to IPE recently for a forthcoming special supplement on smart beta, the CIO of the UK’s Environment Agency Pension Fund, Mark Mansley, noted the lack of product development in fixed income.
“The anomalies in bond and credit markets are even greater than in equities,” he said.
“We would like to see more products and ideas out there for us to harvest.
“Perhaps we are still in the early days of this: the bond market has had things its own way for 20 or 30 years, and, now that the tide is turning, perhaps more innovative thinking will come to the fore.”
The Environment Agency’s Active Pension Fund uses Legal & General Investment Management to implement a global equity mandate that passively tracks a FTSE RAFI benchmark.