What to expect from a well-behaved index
Matthew Levine introduces the IPE survey of Euro bond indices
The advent of the euro has brought in its train a whole assortment of bond indices denominated in the new currency. These include indices specialising in government bonds, or investment-grade corporates, or high-yield securities, or various hybrids of these groups. Institutional investors and trustees could be forgiven for being bewildered by this array of new products.
This article highlights some useful landmarks to guide them through the maze.
There are several major trends within the bond markets, and more narrowly in the pensions industry, which point to a continued expansion of investment in European bonds. The main reasons for this trend are:
q Historically low yields on government debt make higher-yielding corporate bonds more tempting for investors.
q Institutional investors such as pension funds and insurance companies are becoming increasingly active players in the bond markets. Greater demand from these institutions is generating more and larger issues.
q The euro has opened up the European bond markets to much greater cross-border trading: bonds aimed at domestic investors have become marginalised, and bond markets have had to adapt.
This pattern of more investors and greater investment in European bonds has created a growing demand for accurate information about the quality of corporate debt and the degree of risk it entails. A growing number and range of euro-based indices which can be used for benchmarks has sprung up to meet this new demand.
In January IPE sent a questionnaire to all the main providers of euro-based bond indices, with detailed questions looking at three broad areas:
q methodology (the main focus of interest);
This article gives a summary of the IPE questionnaire results. It also puts the results in the context of a more general look at the desirable qualities for a bond index.
Bond indices fulfil several different functions. Three important ways in which they are used are:
q As the basis of an index-tracking fund. A bond index should ideally be a good proxy for the target market which it is designed to track. A common way of achieving this is by weighting the bonds that are members of an index in proportion to their size (ie market capitalisation) within the market.
Managers of passive bond funds can track such an index and feel secure that it is capturing the underlying behaviour of the target market. Since the performance of passive funds depends almost entirely on the composition of the index, investors are likely to prefer indices which are well-diversified by sector, maturity and credit rating.
q As a benchmark. Bond indices are also used as benchmarks for actively-managed bond portfolios. Benchmark indices provide a target level of performance against which to measure an active fund’s behaviour. The composition of an index may be less crucial when it is used for benchmarking as opposed to index-tracking. However, its projected return and risk profiles will come under scrutiny from pension fund trustees who are seeking a balance between achieving healthy returns on one hand, and minimising the risk of failing to match their liabilities on the other. They are likely to choose a benchmark index which dovetails most closely with their preferred balance of risk and return. This may not be the most diversified index with the widest coverage across the market, which might be the passive investor’s choice.
q As an analytical tool. A third use for bond indices is to compare performance, risk and other factors over time between different parts of a market. Investors and fund managers welcome the opportunity to ‘slice and dice’ a stock universe in different ways in order to gain a deeper understanding of how the universe’s behaviour is built up of many components. Common ways of dividing a bond index into such components are by maturity, by credit rating, by sector and industry, and by country. Ultimately, sub-indices aid investors in making asset allocation decisions within their bond portfolios.
Participants in the bond markets have different perspectives on the qualities of good indices, and it is revealing to compare these views. A variety of roles exist in the markets, from the index regulator to the purchasers and the index providers themselves. The table compares the desirable index qualities cited by the index regulator, the European Federation of Financial Analyst Societies (EFFAS), and by two fund managers who have chosen bond indices for their portfolios during the past year. The managers had different aims. One wanted to use an index as a benchmark for measuring performance, the other was seeking a suitable index to track with a passive fund. The perspective of the index providers themselves is addressed in the survey summary.
The table entries are divided into five broad index criteria for ease of comparison.
All of the participants mention more qualities relating to methodology than any other issue. This provides some independent support for IPE’s focus on methodology in the current survey.
IPE asked index providers to complete a separate questionnaire for each of their euro-based indices, rather than a catch-all response about their general strategies. There were responses from 10 providers covering 22 indices. The focus is on index methodology.
However, some questions do come under other areas covered by the table on desirable index qualities. For example, there are questions about data sources and about how index information is communicated to users.
Some interesting observations from the survey include:
q Membership of all of the surveyed indices is based on objective rules, and in most cases there is no subjective element to the decision.
q There is huge variation in the size and composition of indices. For example, Datastream’s EMU benchmark index is composed of a single government bond from each maturity category and has only eight constituents. At the other extreme, Merrill Lynch’s EMU Broad Market index has over 5,000 constituents and includes both government and corporate bonds.
q For indices covering corporate bonds, there are different approaches on whether to include unrated bonds.
q Prices for the bonds in the indices usually come from the index provider’s own traders. For about a third of the indices the source of prices is a third party.
q There is some variation in how index data is communicated. Some providers focus on one method of communication, such as data vendors or the company website, others use all of the suggested means of communication.
IPE’s survey and this discussion of Euro-based bond indices suggest that index users are becoming ever more sophisticated. The range of products on offer is growing, but there is an equal emphasis on providing indices with objective rules and the flexibility for users to customise them according to their priorities. With continued technological advances, the diversity and quality of index products is likely to grow further.
Matthew Levine is with the investment consulting practice at Bacon & Woodrow in London