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 Fixed-income indexes have always been considered a different index breed because of their complexity and the distinct challenges of managing against them, especially compared with their equity index counterparts. The fixed-income investment universe is much larger and includes securities issued by government, public sector and private sector entities. Index turnover is higher, as outstanding debt matures and new debt is issued continually to meet a particular issuer’s financing needs. Instruments are generally traded over the counter rather than on an exchange, making it imperative for index providers to be directly tied to the markets to price and value index-eligible instruments accurately. Finally, accurate bond-level analytics and other risk measures are as important for index users as calculated index returns.
To manage effectively against a fixed-income index or to obtain fixed-income beta, the importance of “knowing thy benchmark” cannot be understated at any step of the portfolio management process, including appropriate benchmark selection, portfolio construction, performance analysis and attribution, and risk management. This applies both to active/passive portfolios measured against an index and to investors who are seeking broad fixed-income beta through index replication, for recombination with other potential alpha sources.
As fixed-income portfolio managers continue to isolate sources of portfolio beta and alpha for repackaging in new innovative ways, we are seeing more widespread use of strategy-based indexes that offer efficient access both to beta and alpha. These indexes are not meant to be explicit benchmarks, but are valuable to portfolio managers for both risk management and hedging, as well as alpha enhancement. The returns of alpha-generating and other strategy-based indexes are appealing to many investors, either in combination with synthetic fixed-income beta or as a part of a larger portfolio search for absolute return alpha. As these techniques filter into the market, the strategies ultimately cease to be a source of true alpha and eventually become a source of alternative beta, placing a premium on the development of new and innovative alpha strategies.
The extreme volatility and negative spread sector returns experienced by most segments of the bond market in 2008 have introduced more challenges to the portfolio management process. As an index provider, Barclays has maintained a constant dialogue with a broad set of fixed-income investors during this difficult market environment and has identified some key, evolving benchmark trends. The most prominent trends affecting fixed-income investors are related to benchmark selection and composition, the volatility of manager returns and performance, the effectiveness of different fixed-income index replication strategies and the evolution and portfolio uses of these alpha-generating strategy indexes.
Trends In Fixed-Income Benchmark Selection And Composition
Benchmark Selection
Broad-based flagship benchmarks that measure the market return (beta) of the investable fixed-income universe remain the dominant benchmark choice among “core” investment-grade portfolio managers. Three of the most widely used fixed-income benchmarks are the Barclays Capital U.S. Aggregate, Global Aggregate and Euro Aggregate Bond Indexes.1 These market-value-weighted measures of the fixed-rate investment-grade bond universe include both government and spread sector bonds, and the U.S. Aggregate Index has a history dating back to 1976. For “core plus” managers, the Barclays Capital U.S. Universal Index (which combines the U.S. Aggregate with U.S. High Yield and Emerging Market Indexes) is also a notable benchmark, although in many cases, core-plus managers still use the U.S. Aggregate as a benchmark, and use high-yield, emerging market and other out-of-index securities as a source of portfolio alpha. High-yield, emerging market, inflation-linked and other fixed-income asset classes each have their own flagship benchmarks both for regional and global investors.
Although these benchmarks are the market standard, many index users and plan sponsors use customized benchmarks derived from these broader benchmarks that set targeted weights for certain sectors or define issuer exposure limits based on specific portfolio guidelines. Common customizations include composite indexes to match the weights of a target asset allocation, broad indexes with more inclusive/restrictive credit quality constraints and issuer-constrained indexes that cap the exposure to issuers within an index. Issuer-constrained indexes tend to be more prevalent for high-yield benchmarks, but there has been increased interest from investment-grade credit managers following the recent consolidation in the banking sector. The complexity of these custom indexes can vary significantly depending on a portfolio manager’s benchmarking needs.
Benchmark Composition
As a measure of the investable bond universe, fixed-income index composition is directly affected both by market events and issuance patterns. Recent trends that will continue to affect benchmark composition in 2009–2010 include greater single-name issuer concentration in the Financial sector due to consolidation and mergers, continued issuance of new government-guaranteed bank debt and an expected surge in Treasury issuance in 2009 and 2010. Investors seeking to “know thy benchmark” must stay keenly aware of these trends.
Direct government guarantees of newly issued bank debt have altered the composition of commonly used government bond indexes. Barclays Capital Indexes classify these higher-rated government-backed securities in the Government-Related sector, as they trade with a tighter spread than their nonguaranteed corporate equivalents and are generally purchased by government portfolio managers. Since the first bond of this type was issued in late 2008, 115 securities with a notional value of $283 billion from 62 different issuers have been added to the Global Aggregate Index.2 As a percentage of the $27 trillion Global Aggregate, these government-guaranteed securities represent only 1 percent by market value, but as a percentage of the Global Government-Related sector, they account for almost 7 percent. Specifically, in the fixed-rate U.S. Aggregate, 32 securities with a notional value of $99 billion have been issued since October 2008.
With the increased borrowing needs of the U.S. Treasury and other global governments, net Treasury sector issuance in 2009 will also be significantly higher. Barclays Capital projects that there will be approximately $2 trillion of new U.S. Treasury issuance in bonds with a maturity greater than two years during 2009, with just $600 billion expected to drop from the U.S. Aggregate Index after falling below one year to maturity. This projected 2009 net inflow of $1.4 trillion will be $1 trillion higher than 2008’s record $382 billion. While it is difficult to project issuance for all index-eligible issuers, Treasuries are likely to represent almost 30 percent of the U.S. Aggregate Index by year-end 2009 (currently at 25 percent of the index by market value).
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