Investing in any exchange-traded funds requires a thorough understanding of the underlying exposure the fund is seeking to achieve and how it is structured. This means understanding how an index is contructed and its underlying biases, as well as the fund’s structure (physical/synthetic, full/sampled replication, ETN, ETC, etc.). In the case of many broad-based fixed income indices, there are some inherent difficulties with building a comprehensive and representative collection of bonds that could make them a less-than-ideal vehicle for stand-alone fixed income investment. Here, we take a closer look at a few of the intrinsic biases and limitations of fixed income benchmarks.
Bloated Balance Sheet Bias
Most fixed income indices are market capitalisation weighted. This works well for equity indices because it invests more money in the largest and most profitable companies, which are presumably among the safest. However, that logic gets flipped when applied to fixed-income securities or debt. Market capitalisation weighting concentrates investment in the obligations of the most heavily indebted issuers. Concentrated exposure to the largest corporate and sovereign debtors carries the obvious risk that these issuers might eventually leverage themselves to the point where they are unable to service their debt.
We can find a prime example of this risk within the Markit iBoxx EUR Liquid Corporates index. This index is the most widely tracked corporate fixed income benchmark in the European ETF universe, as measured by assets under management. This index has a high degree of sector concentration, with 42% of its value being represented by bonds issued by banking sector companies. Though the worst of the financial crisis is behind us and most banks cleared the recent round of stress tests, this strong sector concentration should make many investors think twice before putting their money in an ETF tracking this benchmark.
Of course, where sector concentration poses a potential problem, index providers are happy to come up with a solution. For those looking to minimise exposure to credit risk amongst Europe’s banks, there are a handful of indices (and ETFs) available which specifically exclude banks’ debt. iShares Markit iBoxx GBP Corporate Bond ex-Financials ETF and Lyxor ETF Euro Corporate Bond ex-Financials have safer-looking but still concentrated exposures to the debt of utilities (31.4%), consumer non-cyclicals (18.9%), and telcommunications (18.7%) firms. Meanwhile, iShares Barclays Capital Euro Corporate Bond ex-Financials ETF has a somewhat more balanced sector exposure amongst utilities (18.5%), telecommunications (18.4%), and consumer non-cyclicals (18.2%).
Another example of bloated balance sheet bias can be found in sovereign bonds. The iBoxx EURO Sovereigns Eurozone Total Return index is presently the most widely tracked sovereign fixed income benchmark in Europe--as measured by ETF assets under management. This market capitalisation weighted index has a concentrated exposure to Italian sovereign debt, which comprises nearly 25% of the index’s value. Furthermore, the combined debts of issuers from the Eurozone’s periphery (Italy, Spain, Portugal, and Ireland) represent 38% of the index. Italy’s ratio of public debt to GDP is at an uncomfortable level of around 115% and 10-year spreads on Italian bonds relative to German bunds have widened dramatically over the past year. The index’s concentrated exposure to Italian sovereign obligations is another key example of the potential pitfalls of market capitalisation weighted fixed income benchmarks.
Ratings Restrictions, Missed Opportunities
Most fixed income indices have credit ratings restrictions baked into their methodology. For example, the aforementioned Markit iBoxx EUR Liquid Corporates index will only include investment grade bonds. While this restriction makes sense within the context of index construction, in actual investment practice the exclusion of sub-investment grade bonds can make for missed opportunities. trying to break through the investment grade ceiling will be excluded from investment grade only benchmarks. Those issuers that succeed in gaining a favourable re-rating of their credit status will typically see their outstanding debt obligations subsequently appreciate in value. Actively seeking out prospects for credit upgrades is one key area where active fixed income managers can add value and where, by their very nature, bond indices are relegated to the sidelines.
More to Come
Bloated balance sheet bias and credit ratings restrictions are just two of the most prominent drawbacks of a passive fixed income benchmark. These aspects of bond indices’ infrastructure create the potential for active managers to add value by avoiding potential credit risks and exploiting possible credit upgrades. In future articles, we will go into greater depth on the ways in which these indices are calculated, the price discovery process within fixed income markets and how it may be evolving with some help from ETFs.
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