Jack Malvey is the former chief global fixed-income strategist for Lehman Brothers, where, among other responsibilities, he oversaw Lehman’s No. 1-ranked debt research department for more than 15 years. Malvey recently discussed both the history and future of the fixed-income indexing market with the editors of the Journal of Indexes.
Journal of Indexes (JoI): Can you talk about the origins of the Lehman Brothers fixed-income indexes and how the indexing market has changed over time?
Jack Malvey (Malvey): Total return bond indices were introduced in 1973 to fill a startling measurement void in financial markets. Equity indices already had a long history by that time. Charles Dow created his Dow Jones Transportation Average way back in 1884, and followed that up with the Dow Jones Industrial Average in 1896. But while long-term series of “bond yield averages” existed since at least the early 20th century (e.g., Moody’s average of select corporate bond yields begins in 1919), in the early 1970s, neither the U.S. bond market nor major non-U.S. debt markets had a comprehensive measure of total return performance akin to equity return indices.
But there was a great need. The great portfolio management innovations of the 1950s and 1960s, especially with respect to asset allocation, could not possibly be applied without a measure of bond market performance. There also were business and personal incentives favoring bond index creation in the early 1970s: Some institutional bond managers rued in the late 1960s/early 1970s that their comparative portfolio performance could not be calculated, which was to their disadvantage (at least in outperformance years) in terms of performance-based compensation schemes.
At the behest of several major institutional investors and bond industry groups, a research team led by Art Lipson at Kuhn, Loeb (acquired by Lehman in 1977) filled this void in July 1973 with the first marketwide U.S. bond return index of U.S. government and corporate bonds (index inception was backdated to Jan. 1, 1973). Salomon Brothers followed approximately two weeks later in July 1973 with a similar index. The closure of this measurement void would not have been possible without the growing availability of low-cost computing technology beginning in the early 1970s.
General bond index philosophy has remained largely unchanged over the past nearly four decades. Index providers fill a vital global capital market need through the provision of broad market, sector, and issuer return and risk data. This index information underpins strategic and tactical asset allocation, and issuer and security selection, and thereby helps render capital markets more efficient.
The bond index market, though, has become far more complex thanks to capital market innovation and globalization. Asset-backed securities, commercial real-estate-backed securities, Pan-European high-yield corporates, public emerging-market debt, and the Eurozone and euro had not been born back in 1973. The Asian, Latin American and Eastern European corporate debt markets barely existed in the 1970s, if at all.
Guided by the intention to complete the “global index map” by adding both newly developed asset classes and all substantive local bond markets to its global family of indices, Lehman deepened its index family from just two components in 1973 (U.S. governments and U.S. corporates) to approximately 15 by 1996, and all the way to about 110 generic indices by early 2009. In turn, these new indices dictated new third- and fourth-generation macro index creations, like the Euro-Aggregate Index, created in 1998.
More recently, debt indices have become not only measurement tools, but also financial products in themselves.
JoI: Were there any conflict issues in the calculation of the Lehman Brothers indexes, and if so, how were they dealt with?
Malvey: As the scale of the global family of indices (including U.S. municipals) skyrocketed since the mid-1990s to include approximately 70,000 securities in early 2009, there were admittedly occasional instances where the pricing of an individual issuer or a specific issue—particularly at month-end—might be debated and even found to be erroneous. These infrequent occurrences tended to be associated with off-the-run, less-liquid corporate borrowers and small securitized tranches. Far less common, transitions of large industries/issuers from investment-grade to high-yield index status, such as the U.S. auto industry in 2005, might invite additional index-user scrutiny. Somewhat surprisingly, chaotic market conditions like the Asian financial crisis of 1997, 9/11 and the “panic of 2008” did not lead to intense external debate over index pricing. Understandably, investors have greater portfolio priorities at such difficult times.
The resolution of index pricing anomalies was a clear and straightforward process. Whether brought to Lehman’s attention by index users or discovered by Lehman’s index production team, affected securities were reevaluated by traders marking the index and verified against third-party pricing. In those extremely rare cases where a mispricing was detected after publication, a pricing correction would be immediately made and, if necessary, where such repricing would materially alter an overall macro index return like the Euro-Aggregate Index or U.S. Aggregate Index by approximately 10 bp or more, the overall index would be immediately rerun with the correct prices and the index results restated.
If the term “conflict” implies “conflict of interest” between Lehman traders/index group and third parties such as investors/other counterparties (especially for index swaps), then I never observed any such conflicts during my 16½ years at Lehman. Stout organizational defenses were in place to guard against such a possibility:
- As mandated by regular compliance reviews, trader-index pricers and index production were separate and distinct groups with different reporting lines;
- Trading desks and index production did not share technology;
- As the global family of indices grew, the price inputs of upward of 100 traders would be included in index calculations, thereby nearly eliminating the ability of any aberrant trader-index pricer to meaningfully affect the overall index; and
- The most important safeguard of all, the completely open and transparent publication on a daily, monthly and yearly basis of the pricing of every single individual constituent of every Lehman index. For nearly four decades, this data has been rigorously reviewed by thousands of institutional investors, hundreds of issuers, dozens of consultants and numerous academics, and has never been found to be tainted by real or perceived conflicts.