The number of fixed-income securities is many times larger than the number of equity securities since fixed-income issuers often issue various types of fixed-income instruments with different characteristics. This expansive universe means that fixed-income indices may have to include thousands of different securities to accurately track its target market. 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).
Which of the following is least likely a challenge in constructing a fixed-income index?
A. Lack of liquidity
B. Difficulty estimating future interest payments
C. Large size of the investment universe
The correct answer is B.
Options A and C are incorrect since they are, in fact, challenges. Fixed-income index managers often struggle with a low amount of liquidity and a high number of securities.
Another challenge is estimating current value for illiquid fixed-income securities, but estimating future interest payments is not a necessary step or challenge in constructing a fixed-income index.
Reading 45 LOS 45i:
Describe fixed-income indices