Passive Bond Market Exposure
Passive bond market exposure is a strategy in the fixed-income market that aims to mirror the overall investment landscape. It considers factors such as credit quality, borrower type, maturity, and duration. The objective is not to express a specific market view, but to emulate the broader fixed-income market performance, aligning with the efficient markets hypothesis.
Benefits of Passive Bond Market Exposure
- It eliminates the need for extensive economic, market, or security analysis for above-market returns.
- It reduces high trading frequency, a characteristic of active management, leading to lower portfolio management and servicing costs.
- It aims to match a broad-based bond index performance, ensuring high portfolio diversification.
Full Replication
Full replication does not necessitate manager analysis. Instead, it involves sourcing a wide variety of securities in the exact proportion to the index. Some of these securities may be thinly traded. The manager’s ongoing task under full replication is to buy or sell bonds when there are changes to the index. This also includes managing inflows and outflows for a specific fund.
For example, consider the Bloomberg Barclays US Aggregate Bond Index. A fixed-income security becomes ineligible when it either has a maturity of less than one year or is downgraded below an average minimum investment-grade rating. Conversely, managers must purchase newly issued securities that meet index criteria to maintain full replication. Depending on the index, this may occur quite frequently. Rolling bond maturities, as well as frequent new issuance eligible for inclusion in the index, necessitate a monthly rebalancing for most fixed-income indexes.
Practicality and Alternatives
The number of purchases and sales required to maintain an exact proportional allocation would be very significant for most bond indexes. As a result, although the large number of index constituents may well provide the best means of risk diversification, in practice it is neither feasible nor cost-effective for investors to pursue full replication for broad-based fixed-income indexes. It is impractical for all but the most narrow indexes. Investors who wish to have exposure to an index would, in practice, rely on one of the many ETFs that exist in this space.
Enhanced Indexing
Enhanced Indexing is a strategy that aims to mirror the most significant characteristics of an index while closely tracking its performance over time. This is achieved by purchasing fewer securities compared to the full replication approach. This strategy is also known as a stratified sampling or cell approach to indexing. The process involves identifying each cell or significant index portfolio characteristic and mapping it to the current index. The fixed-income portfolio manager then identifies a subset of bonds or bond-linked exposures with characteristics that correspond to the index. The positions in each cell are adjusted over time given changes to the underlying index versus existing portfolio positions.
For instance, if a fixed-income index contains 1,000 fixed-income securities, 10% of which are AAA rated, the portfolio manager might choose 5–10 AAA rated securities within a cell to mimic the performance of the AAA rated bonds within the index. Enhanced indexing is crucial for investors who consider environmental, social, or other factors when selecting a fixed-income portfolio. Additional categories include sustainability, which includes companies addressing their ESG risks, and green bonds, which fund projects with direct environmental benefits.
Incorporating ESG Factors in an Index
There are two main components to incorporating ESG factors in an index. The first is a business involvement screen that excludes issuers involved in business lines or activities such as alcohol, gambling, tobacco, adult entertainment, nuclear power, and firearms. The second is an ESG rating, provided by one of numerous third-party companies. MSCI, for example, provides ratings on an “AAA to CCC” scale using a rules-based methodology according to the companies’ exposure to ESG risks and how well they are managed relative to peers.
When building a sustainable index, Bloomberg will apply rules as those previously described and then further filter the constituents for business involvement and an MSCI minimum rating requirement of BBB. Given the proliferation of ESG data providers, there are differences across methodologies and ratings. It’s important to note that the pillar of ESG that may be most important to an investor may not have the same emphasis in the rating criteria used by the index provider.
Enhancement Strategies
Enhancement strategies are techniques to optimize portfolio performance and minimize tracking error, as outlined by Volpert (2012). Key strategies include:
- Lower Cost Enhancements Reduction of fund expenses through negotiation of lower service provider fees and competitive trading processes to decrease transaction costs, akin to Amazon’s supplier negotiations.
- Issue Selection Enhancements Identification of undervalued bonds using models like the Gordon Growth Model to maximize returns, similar to finding discounted high-quality items.
- Yield Curve Enhancements Use of models like Nelson-Siegel to evaluate interest rate term structures and strategically choose undervalued maturities, paralleling a real estate investor’s selection in undervalued areas.
- Sector/Quality Enhancements Adjustment of weights in specific bond and credit sectors according to the business cycle to boost returns, resembling a farmer’s crop rotation strategy.
- Call Exposure Enhancements Management of bonds anticipating large yield changes, enhancing call protection and mitigating tracking risks, similar to insurance companies adjusting premiums for heightened risks.
Utilizing a stratified sampling method allows for optimal performance with fewer securities, closely aligning with the index to minimize tracking error and reduce transaction needs.
Alternatives to Direct Investing in Fixed-Income Securities
Investment managers often seek alternatives to direct investing in bonds to achieve index-based exposure and enhanced liquidity. These alternatives include Exchange-Traded Funds (ETFs) and Index-Based Total Return Swaps.
Exchange-Traded Funds (ETFs)
ETFs are traded products that offer superior liquidity compared to the underlying securities. For instance, consider the iShares Core U.S. Aggregate Bond ETF (AGG), which provides broad exposure to U.S. investment-grade bonds. ETFs can be bought or sold throughout the trading day, offering investors more flexibility than mutual funds. ETFs authorized participants, who have an agreement with the fund’s distributor, can engage in arbitrage to profit from any significant divergence between the market price of the underlying fixed-income securities portfolio and an ETF’s net asset value (NAV). However, the fact that many fixed-income securities are either thinly traded or not traded at all might allow such a divergence to persist.
Index-Based Total Return Swaps
Total return swaps are over-the-counter derivative instruments that allow for the periodic exchange of cash flows between two parties throughout the life of the contract. Typically, one party (e.g., a bank) agrees to pay the other party (e.g., a hedge fund) the total return of a specific index like the S&P 500, which includes both the cash flows and any capital gains from the index.
- Counterparty Obligations: In return, the hedge fund pays the bank a fixed interest rate plus a predetermined spread over a benchmark rate, commonly the Market Reference Rate (MRR). The total return receiver is thus responsible for the ongoing payment of MRR plus the spread, while gaining the benefits of the index’s performance.
- Risks and Benefits: The total return payer (the bank, in this example) covers the cash flows and returns of the index to the receiver but also receives compensation for any losses, including depreciation in the index value or defaults within the underlying assets. This swap arrangement provides several advantages, including reduced initial cash outlay compared to direct investments in similar assets, such as bonds in a mutual fund or ETF.
- Access to Illiquid Assets: As a customizable derivative, a TRS can provide exposure to asset classes that are challenging to access directly, including certain high-yield bonds and commercial loans. This makes it a valuable tool for sophisticated investors seeking to diversify their portfolios or target specific returns.
- Counterparty Credit Risk: Despite its benefits, engaging in a TRS carries counterparty credit risk, meaning the financial stability and reliability of the opposing party in the swap can impact the expected returns and overall risk exposure of the deal.
Practice Questions
Question 1: An investor is considering different investment strategies in the fixed-income market. He is particularly interested in a strategy that replicates the characteristics of the overall investments available, including factors such as credit quality, type of borrower, maturity, and duration. He is not interested in expressing a specific market view, but rather wants to mimic the broader fixed-income market performance. Which investment strategy best suits the investor’s preferences?
- Active bond market exposure
- Passive bond market exposure
- Enhanced indexing strategy
Answer: Choice B is correct.
The investment strategy that best suits the investor’s preferences is Passive bond market exposure. Passive investing is a strategy that aims to replicate the performance of a specific benchmark or index. In the context of the fixed-income market, a passive strategy would involve creating a portfolio that mirrors the characteristics of the overall market, including factors such as credit quality, type of borrower, maturity, and duration. This strategy does not involve making specific bets on the direction of the market or individual securities, but rather seeks to match the broader market performance. This is exactly what the investor in the question is looking for. Passive investing is typically less risky and less costly than active investing, as it does not involve frequent trading or the need for extensive research and analysis.
Choice A is incorrect. Active bond market exposure involves making specific investment decisions based on a view of the market or individual securities. This could involve selecting specific bonds, adjusting the portfolio’s duration or credit quality, or making other tactical decisions. This is not what the investor in the question is looking for, as he does not want to express a specific market view.
Choice C is incorrect. An enhanced indexing strategy is a hybrid of active and passive investing. It involves creating a portfolio that closely tracks a specific index, but also allows for some active management in an attempt to outperform the index. This strategy involves more risk and cost than pure passive investing, and is not what the investor in the question is looking for, as he does not want to take on additional risk or cost in an attempt to outperform the market.
Question 2: A portfolio manager is looking for an investment strategy that does not require in-depth economic, market, or security analysis to achieve an above-market return. The manager also wants to avoid high trading frequency and aims to match the performance of a broad-based bond index. Which investment strategy should the portfolio manager consider?
- Active bond market exposure
- Passive bond market exposure
- Enhanced indexing strategy
Answer: Choice B is correct.
The portfolio manager should consider Passive Bond Market Exposure. Passive investing is a strategy that aims to maximize returns over the long term by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. Passive management simply tracks a market-weighted index or portfolio. The benefits of such a strategy include broad diversification, low turnover, and low management fees. Since the manager is looking to match the performance of a broad-based bond index and wants to avoid high trading frequency, passive bond market exposure is the most suitable strategy. This strategy does not require in-depth economic, market, or security analysis to achieve an above-market return, which aligns with the manager’s requirements.
Choice A is incorrect. Active bond market exposure requires in-depth economic, market, and security analysis to achieve an above-market return. It involves frequent trading and incurs high management fees, which is not what the manager is looking for.
Choice C is incorrect. An enhanced indexing strategy is a hybrid between active and passive management. It seeks to generate excess returns compared to a benchmark index while closely tracking its performance. This strategy requires some level of in-depth economic, market, or security analysis and may involve higher trading frequency than a purely passive strategy, which does not align with the manager’s requirements.
Glossary
- Enhanced Indexing Strategy: A method of establishing passive bond market exposure that involves slightly deviating from the index in an attempt to generate excess returns.
- Full Replication: A strategy where a fund manager mimics the performance of a specific index by sourcing a wide variety of securities in the exact proportion to the index.
- Enhanced Indexing: A strategy that aims to mirror the most significant characteristics of an index while closely tracking its performance over time.
- Business Involvement Screen: A filter that excludes issuers involved in certain business lines or activities from an index.
- ESG Rating: A rating provided by third-party companies, based on a company’s exposure to ESG risks and how well they are managed.
- Tracking Error: The divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark.
- Effective Duration: A duration calculation for bonds that have embedded options.
- Exchange-Traded Funds (ETFs): Investment funds traded on stock exchanges, much like individual stocks.
Portfolio Management Pathway Volume 1: Learning Module 4: Liability-Driven and Index-Based Strategies.
LOS 4(f): Compare alternative methods for establishing bond market exposure passively