Fixed-income Indices

Construction

The number of fixed-income securities is often larger than that 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.

Options A and B 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 arises when it comes to figuring out the present value of illiquid fixed-income securities. But, unlike this challenge, estimating future interest payments is not a required part or a problem when creating a fixed-income index.