Benchmark Selection

Choosing the right benchmark for fixed-income securities is a crucial task that involves understanding a client's goals and limitations. Matching the benchmark to the liability or portfolio is essential, but it's more straightforward for equities than fixed income due to specific challenges:

• Maturity Mismatch: Bonds, both in the benchmark and the portfolio, have varying maturities, making it challenging to align them when they are continually changing.
• Issues with Value Weighted Indices: These indices give more weight to issuers with more securities, leading to creditworthiness issues as riskier issuers often have more securities.

In practice, custom indexes are often used, such as a blend of short-term and long-term treasury securities. These custom indexes match the duration of a liability or portfolio.

Smart Beta in Custom Indexing

Smart beta is related to custom indexing but involves creating an index with specific rules to capture risk factors, combining aspects of passive and active investing. The aim is to outperform while maintaining lower costs than active management.

Question

According to the bums problem, what relationship most likely exists between the creditworthiness of an issuer and the number of respective issues outstanding on any given index?

1. No direct relationship.
2. Positively related.
3. Negatively related.

Solution

The correct answer is C.

The Bums Problem:

The bums problem refers to a phenomenon observed in the bond market. It suggests that less creditworthy issuers tend to issue more securities. In other words, as the creditworthiness of an issuer decreases, the number of issues they put out into the market increases.

Explanation:

Riskier issuers (those with lower creditworthiness) often face challenges in attracting investors. To compensate for this, they issue a larger number of bonds or securities. This behavior results in a negative relationship between creditworthiness and the number of issues outstanding.

Remember, the bums problem highlights that credit risk and issuance volume are inversely related. So, when considering an index, keep this negative relationship in mind.

A is incorrect: No direct relationship:

This answer suggests that there is no relationship between the creditworthiness of an issuer and the number of issues outstanding.

However, this contradicts the bums problem, which specifically highlights a negative relationship between creditworthiness and issuance volume.

In reality, there is indeed a direct relationship (albeit an inverse one) between creditworthiness and the number of issues.

B is incorrect: Positively related:

This answer implies that as creditworthiness increases, the number of issues also increases.

However, this contradicts the bums problem, which shows that riskier issuers (with lower creditworthiness) tend to issue more securities.

Therefore, the relationship is not positive; it’s actually negative.

Reading 20: Liability-Driven and Index-Based Strategies

Los 20 (i) Discuss criteria for selecting a benchmark and justify the selection of a benchmark