The Trouble with Fixed Income Indices

BOND WEEK: Fixed income indices and their ETFs may have some inherent shortcomings

Ben Johnson 5 October, 2010 | 12:37AM
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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.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.