Fixed-income Indices

Construction

The number of fixed-income securities is often larger than the number of equity securities since fixed-income issuers often issue various fixed-income instruments with different characteristics. This expansive universe means that fixed-income indices may have to include thousands of different securities to track their target market accurately. Additionally, these markets lack liquidity, and index providers must contact dealers to obtain prices or even estimate prices based on other securities with similar characteristics. These challenges make it more difficult and costly for investors to replicate fixed-income indices.

Types of Indices

Fixed income securities may be classified by the issuer’s economic sector, geographic region, or the economic development of the issuer’s region. Classification may also be based on the type of issuer or financing, the currency of payments, maturity, credit quality, or the presence of inflation protection. Fixed-income indices are further categorized into aggregate or broad market indices, market sector indices, style indices, economic sector indices, and specialized indices (high-yield, inflation-linked, emerging market).

Question

Which of the following is least likely a challenge in constructing a fixed-income index?

1. Lack of liquidity .
2. Large size of the investment universe.
3. Difficulty estimating future interest payments.

Solution

The correct answer is C.

Difficulty estimating future interest payments is not a major challenge in fixed-income index construction because the index is based on current bond characteristics and does not require forecasting future interest payments. The primary challenges in fixed-income index construction are more related to liquidity issues and managing the large and diverse universe of bonds.

A is incorrect. Lack of liquidity: This is a common challenge in fixed-income markets, especially for certain types of bonds or for bonds issued by smaller or less frequently traded issuers. Liquidity issues can make it difficult to construct an index that accurately reflects the performance of the underlying market.

B is incorrect. Large size of the investment universe: Fixed-income markets can indeed be very large and diverse, with a vast array of bonds issued by different entities, including governments, corporations, and municipalities. This large universe can pose challenges in terms of index construction, as it can be difficult to select and manage a representative sample of bonds.