Fixed-Income Universe and Bond Market Index
Investors often diversify their portfolio by allocating a portion of their assets to the fixed-income universe, drawn by the risk-return characteristics of bond markets. A strategy based on a bond market index provides a broader exposure to this universe. This index-based investment strategy offers benefits such as increased diversification, lower fees, and the avoidance of downside risk associated with active management.
Immunization and Tracking Risk
Investors may use immunization to offset specific liabilities, measuring the success of their strategy by how closely the chosen bonds offset future liabilities under varying interest rate scenarios. Conversely, those seeking to match the returns of a bond market index measure success by how closely their chosen portfolio mirrors the return of the underlying index. The deviation of returns from the index is known as tracking risk or tracking error.
Methods to Match an Underlying Market Index
There are several methods to match an underlying market index. The first is pure indexing, where the investor replicates an existing market index by purchasing all constituent securities, minimizing tracking risk. This is known as the full replication approach. In an enhanced indexing strategy, the investor purchases fewer securities but matches primary risk factors reflected in the index, aiming to replicate index performance more efficiently by minimizing transaction costs and problems associated with unique bond characteristics.
Active Management and Bond Market Indexes
Active management involves taking positions in primary risk factors that deviate from those of the index to generate excess return. Casual financial market observers usually refer to an equity market index to gauge overall financial market sentiment. However, when bond markets are mentioned, the price and yield of the most recently issued benchmark government bond is typically referenced rather than a bond market index.
Challenges in Replicating a Bond Market Index
Investments based on bond market indexes form a substantial proportion of financial assets held by investors. However, the unique characteristics of fixed-income markets make them difficult to track, posing significant challenges in replicating a bond market index. These challenges include the size and breadth of bond markets, the wide array of fixed-income security characteristics, unique issuance and trading patterns of bonds versus other securities, and the effect of these patterns on index composition and construction, pricing, and valuation.
Size and Breadth of the Fixed-Income Universe
Fixed-income markets play a vital role in the global financial ecosystem, significantly surpassing equity markets in both size and diversity. While the MSCI World Index, which represents equities from 23 developed countries, includes around 1,600 securities, the Bloomberg Barclays Global Aggregate Index, a benchmark for global investment-grade debt, contains over 16,000 securities. This highlights the expansive nature and crucial role of fixed-income markets in providing investment opportunities and economic stability worldwide.
Range of Borrowers in Fixed-Income Markets
Fixed-income markets feature a more extensive range of issuers compared to equity markets. This diversity is illustrated by the Bloomberg Barclays US Aggregate Index, which encompasses various types of securities including US Treasuries, government agency securities, corporate bonds, and mortgage-backed securities. This broad spectrum of borrowers reflects the wide variety of funding needs and financial strategies across different sectors of the economy.
Challenges in Index Replication
Despite the extensive diversification potential offered by the large number of securities in fixed-income indices, replicating these indices fully is neither practical nor cost-effective for most investors. This is due to the vast scale of the indices and the complexity involved in purchasing and managing such a large number of diverse securities.
Diversity and Characteristics of Bond Issues
The bond market presents a wide array of public and private debt instruments, each with distinct characteristics. For example, Apple Inc. has issued 60 bonds in five different currencies with a variety of features including fixed and floating interest rates, and maturities ranging from under a year to as long as 2061. The diversity within a single issuer’s bond offerings can lead to significant variations in liquidity and performance, influenced by factors such as issuance date, maturity, and how the bond’s coupon compares with current yields needed to price the bond at par.
Unique Issuance and Trading Patterns
Fixed-income markets, unlike equity markets, primarily operate over-the-counter (OTC) and rely heavily on broker/dealers to facilitate trades. These markets use a quote-based execution process, contrasting with the order-based trading systems of equity markets. However, recent changes in regulatory requirements and market structure have significantly impacted the operation and liquidity of these markets.
Impact of Basel III Capital Requirements
The implementation of Basel III capital requirements has increased the cost of maintaining risk-weighted assets on dealer balance sheets. This has led to a decrease in trading inventories, limiting the ability of dealers to facilitate trading at narrow bid-offer spreads and support larger block trades. As a result, broker/dealers have reduced bond inventories due to higher capital costs, preferring execution in smaller trade sizes. This has negatively impacted fixed-income trading and liquidity.
Decline in Proprietary Trading
There has been a significant decline in proprietary trading among dealers, which has had a greater pricing effect on less liquid or off-the-run bonds. While these structural changes in fixed-income trading are seen as a catalyst for more electronic trading, this trend is expected to be most significant for the most liquid fixed-income securities in developed markets. The effect on less frequently traded fixed-income securities worldwide is expected to be more gradual.
Regulatory Reporting Systems
In some markets, regulators have developed systems that facilitate mandatory reporting of over-the-counter transactions in eligible fixed-income securities, such as the US Trade Reporting and Compliance Engine (TRACE) system. All broker/dealers that are Financial Industry Regulatory Authority (FINRA) member firms must report corporate bond transactions within 15 minutes of occurrence.
Trading and Valuation Challenges
The vast majority of fixed-income securities either do not trade at all or trade only a few times during the year. Only a small fraction trade every business day. The average trade size in dollar terms in the US investment-grade bond market is roughly 70 times the size of the average stock trade. The illiquid nature of most fixed-income instruments gives rise to pricing and valuation challenges for asset managers.
Matrix Pricing
For fixed-income instruments that are not actively traded and therefore do not have an observable price, it is common to use an estimation process known as matrix pricing or evaluated pricing. This process uses observable liquid benchmark yields, such as Treasuries of similar maturity and duration, as well as the benchmark spreads of bonds with comparable times to maturity, credit quality, and sector or security type to estimate the current market yield and price.
Challenges in Managing an Index-Based Bond Portfolio
The complexity of trading and valuing individual fixed-income securities underscores the challenges associated with managing an index-based bond portfolio. Fixed-income indexes change frequently due to new debt issuance and the maturity of outstanding bonds. Bond index eligibility is also affected by changes in ratings and bond callability. As a result, rebalancing of bond market indexes usually occurs monthly rather than semi-annually or annually as it does for equity indexes.
Primary Risk Factors
Understanding the primary risk factors is critical in the management of fixed-income portfolios. Key areas of focus include:
- Portfolio Modified Adjusted Duration: This involves measuring the bond price’s sensitivity to interest rate changes and includes calculations for effective duration, option-adjusted duration, and convexity adjustments.
- Key Rate Duration: Assesses the impact of rate changes at specific points along the yield curve, important for managing yield curve exposure.
- Percent in Sector and Quality: Achieves yield matching by ensuring the portfolio’s sector and quality weights align with those of the benchmark index.
- Sector and Quality Spread Duration Contribution: Matches index duration contributions by sector and quality to minimize benchmark deviations.
- Sector/Coupon/Maturity Call Weights: Targets matching callable bond weights by sector, coupon, and maturity, crucial for managing refinancing risks in the mortgage sector.
- Issuer Exposure: Manages issuer-specific event risk by matching portfolio duration effects across issuers.
Present Value of Distribution of Cash Flows Methodology
- Cash Flow Segmentation: The methodology begins with the division of cash flows from non-callable securities within an index into discrete semi-annual periods. These are then aggregated. Additionally, cash flows from callable securities are included based on the likelihood of each security being called within those periods.
- Present Value Calculation: The present value of these aggregated cash flows is computed for each semi-annual period. The total of all these present values equals the overall present value of the index. Each period’s cash flow is then expressed as a percentage of the index’s total present value.
- Time Period and Vertex Contribution: Each cash flow period is then multiplied by its proportionate share of the total index, reflecting the effective duration of each cash flow. For instance, if the third vertex (18 months) accounts for 3% of the total cash flows, its contribution to the overall duration is calculated as 1.5 years multiplied by 3%, resulting in 0.045 years.
- Duration Summation: To compute the index’s total duration, each period’s contribution to duration is summed. By aligning the portfolio’s cash flow distribution in this manner, it mirrors the benchmark’s duration, effectively protecting the portfolio from yield curve shifts and related deviations.
Tracking Error
The goal of matching these primary indexing risk factors is to minimize tracking error, the standard deviation of a portfolio’s active return for a given period.
$$ \text{Active Return} = \text{Portfolio Return} – \text{Benchmark Index Return}$$
If a fund’s tracking error is 50 bps, then for approximately two-thirds of the time period observations, we would expect the fund’s return to be less than 50 bps above or below the index’s return.
Practice Questions
Question 1: An investor is considering different strategies to gain exposure to the fixed-income universe. They are considering a strategy based on a bond market index for its risk versus return characteristics. They are aware of the different methods to match an underlying market index, including pure indexing and enhanced indexing. In the context of these strategies, which of the following statements is correct?
- Pure indexing involves purchasing all of the constituent securities in the index to minimize tracking risk, while enhanced indexing involves taking positions in primary risk factors that deviate from those of the index to generate excess return.
- Enhanced indexing involves purchasing all of the constituent securities in the index to minimize tracking risk, while pure indexing involves taking positions in primary risk factors that deviate from those of the index to generate excess return.
- Pure indexing involves purchasing all of the constituent securities in the index to minimize tracking risk, while enhanced indexing involves purchasing fewer securities than the full set of index constituents but matches primary risk factors reflected in the index.
Answer: Choice A is correct.
Pure indexing and enhanced indexing are two different strategies used to gain exposure to the fixed-income universe. Pure indexing involves purchasing all of the constituent securities in the index to minimize tracking risk. The goal of this strategy is to replicate the performance of the index as closely as possible. This is achieved by holding the same securities in the same proportions as the index. This strategy is passive in nature and does not involve any active management or attempts to outperform the index. On the other hand, enhanced indexing involves taking positions in primary risk factors that deviate from those of the index to generate excess return. This strategy is a hybrid of passive and active management. It involves tracking the index but also taking on additional risk in an attempt to outperform the index. This is achieved by taking positions in securities or risk factors that are expected to outperform the index. Therefore, choice A correctly describes the strategies of pure indexing and enhanced indexing.
Choice B is incorrect. Enhanced indexing does not involve purchasing all of the constituent securities in the index to minimize tracking risk. This is a characteristic of pure indexing. Similarly, pure indexing does not involve taking positions in primary risk factors that deviate from those of the index to generate excess return. This is a characteristic of enhanced indexing. Therefore, choice B incorrectly describes the strategies of pure indexing and enhanced indexing.
Choice C is incorrect. While it is true that pure indexing involves purchasing all of the constituent securities in the index to minimize tracking risk, enhanced indexing does not necessarily involve purchasing fewer securities than the full set of index constituents. Enhanced indexing involves taking positions in primary risk factors that deviate from those of the index to generate excess return, which may or may not involve purchasing fewer securities than the full set of index constituents. Therefore, choice C does not accurately describe the strategy of enhanced indexing.
Question 2: An investor is seeking to offset a specific liability through immunization and is measuring the success of their strategy based on how closely the chosen bonds offset the future liability or liabilities under different interest rate scenarios. In this context, which of the following statements is correct?
- The deviation of returns on the selected portfolio from bond market index returns is referred to as tracking risk or tracking error.
- The deviation of returns on the selected portfolio from bond market index returns is referred to as immunization risk or immunization error.
- The deviation of returns on the selected portfolio from bond market index returns is referred to as liability risk or liability error.
Answer: Choice A is correct.
The deviation of returns on the selected portfolio from bond market index returns is referred to as tracking risk or tracking error. In the context of immunization, an investor is seeking to offset a specific liability through a bond portfolio. The success of this strategy is measured based on how closely the chosen bonds offset the future liability or liabilities under different interest rate scenarios. The difference between the portfolio’s returns and the bond market index returns is known as the tracking risk or tracking error. This is a measure of how well the portfolio is performing in relation to the market index. A low tracking error indicates that the portfolio is closely following the market index, while a high tracking error suggests that the portfolio is deviating from the index. This is a key measure for investors who are seeking to match or beat the performance of a specific market index.
Choice B is incorrect. There is no such term as immunization risk or immunization error. Immunization is a strategy used to manage interest rate risk by matching the duration of assets and liabilities. The goal of immunization is to ensure that the portfolio’s value remains stable regardless of changes in interest rates.
Choice C is incorrect. Liability risk or liability error is not a term used to describe the deviation of returns on the selected portfolio from bond market index returns. Liability risk refers to the risk that a company or individual will not be able to meet its financial obligations. In the context of immunization, the goal is to minimize this risk by matching the duration of assets and liabilities.
Glossary
- Pure Indexing: A strategy where the investor replicates an existing market index by purchasing all of the constituent securities in the index.
- Full Replication Approach: A method of pure indexing that aims to minimize tracking risk.
- MSCI World Index: A stock market index of ‘world’ stocks. It is maintained by MSCI Inc., formerly Morgan Stanley Capital International.
- Bloomberg Barclays Global Aggregate Index: An index used by bond funds as a benchmark to measure their relative performance.
- Over-the-counter (OTC): A decentralized market where securities are traded directly between two parties, without a broker.
- Basel III: A set of international banking regulations developed to promote stability in the international financial system.
- Proprietary Trading: When a firm trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments, with its own money as opposed to its customers’ money, so as to make a profit for itself.
- Matrix Pricing: A technique used to estimate the fair value of a security that is not actively traded.
- Effective Duration: The sensitivity of a bond’s price to a change in a benchmark yield curve.
Portfolio Management Pathway Volume 1: Learning Module 4: Liability-Driven and Index-Based Strategies.
LOS 4(e): Discuss bond indexes and the challenges of managing a fixed-income portfolio to mimic the characteristics of a bond index