Ten Questions With Jack Malvey

April 20, 2009


JoI: How accurate is bond pricing?

Malvey: Overall bond pricing and index returns should be judged as extremely accurate. As measured by bond indices, the trajectory of bond market returns through time is mainly governed by perturbations of local Treasury yield curves and, for international indices, currency movements. Treasury prices and currency movements have long been displayed on a real-time basis out to several decimal places on multiple vendor screens. In the domain of spread sectors (corporates, agencies, MBS, CMBS, ABS), agency and MBS prices also are largely available on real-time pricing screens. Corporate bond pricing also has improved thanks to third-party pricing reference services like TRACE. In certain smaller regions of the world bond market and during periods of generalized illiquidity in spread sectors, there is room for pricing improvement. Not every securitized tranche and small corporate issue by an infrequent issuer trades on a daily basis.

Especially during periods of general capital market stress, sharp variations in market-liquidity provisions by the shrinking cadre of major broker-dealers also can widen bid/ask spreads, especially in the lower-quality markets, and instigate a debate about the appropriate daily mark for some securities. Typically, such debates are infrequent and have virtually no effect on the overall return of a macro index consisting of several thousand securities.

JoI: What are your thoughts on the pluses and minuses of single-source and multisource pricing in fixed-income indexes?

Malvey: A couple of debt index consortia, newly formed over the past decade, have staked an appealing advertising claim of supposed index superiority based on multisource/multicontributor pricing inputs. A multicontributor index enhances its long-run odds of survivorship and continuity but not necessarily its pricing quality, particularly if contributing members vary in their index-pricing commitment.

In reality, pure single-sourced major debt index organizations ceased to exist sometime in the late 1980s/early 1990s. All perceived single-source bond index providers rely on bond price vendors and other external sources for prices to run verification algorithms and to directly price some portions of the world bond market where an in-house pricing capability may not exist. For example, Lehman used third-party pricing vendors for such areas as Canadian corporates, Danish mortgage-backed securities and German Pfandbriefe. And, as publicly announced in 2006, the index groups of Lehman [now Barclays Capital] and Citi/Salomon exchange investment-grade index prices on a daily basis for mutual verification purposes.

The consultant, plan sponsor and investor selection of a debt index provider should be based on many factors, with constituent index pricing among the least important given its equivalence across both equity and now debt index providers. The greatest emphasis should be placed on the “total index service equation.” Specifically, existing and prospective index users should also include in their evaluations:

  1. The accompanying analytics and technology, if any, available to fully exploit the use of a designated index and to better understand the dynamic sources of relative portfolio risk and return;
  2. Additional index services provided by an index research team and by fellow firm researchers, usually found in the product and quantitative strategy groups.

This is not to suggest that the reliance on any single index provider comes without risk. As sadly witnessed firsthand in September 2008—although daily index production was sustained without interruption—the demise of Lehman Brothers certainly reminded investors of business continuity risk. As suggested in basic portfolio theory and as already practiced by large asset management firms, index diversification ranks as the prime antidote to index business continuity risk.


JoI: What should investors take away from the 2007–2009 global economic crisis and some of the wide spreads that developed in fixed-income indexes at that time?

Malvey: Like all major historical events, the stunning breadth and depth of this first “neo-modern credit recession” of 2007–2010 will inspire lessons to be learned and applied for years to come. The absorption of these lessons, not all readily apparent in mid-2009, likely will consume the first half of the 2010s. Real lessons also will be accompanied by exaggerated anxieties about the far-fetched possibility of such events as the resurrection of 1930s-style protectionism, a retreat of globalization and even the potential demise of modern capitalism. Without going out on a limb, the late 20th-century global capital market regime will be recalled as having been upended in 2008. The next-generation, truly 21st-century capital market framework is already under construction and hopefully will provide a potent bulwark against a reoccurrence of the many faults of its conspicuously deficient predecessor.

The preliminary takeaways from this early 21st-economic/market misadventure include:

  1. Ignorance of or ignoring the rich capital-market history of the past two centuries can be highly hazardous to portfolios;
  2. Global trade and capital flow imbalances are not sustainable infinitely;
  3. Residential and commercial real estate valuations do not continuously escalate;
  4. Recurring systemic government, corporate and consumer credit misdiagnoses continue to plague the world financial system despite two centuries of remediation efforts;
  5. Financial institution and consumer financial leverage have limits and will be recalibrated lower to the more-conservative standards of the post-Great Depression era extending from the 1940s to the early 1980s;
  6. Recurring fallibility of institutions (certain financial institutions, rating agencies) and financial risk models will be better understood and mitigated, although not ended;
  7. Antiquated regulatory and government oversight methodologies will be overhauled, with enhanced global coordination and inevitable additional scrutiny of rating agencies and certain types of alternative asset managers;
  8. As in the aftermath of every monumental market shock accompanied by poor investment performance, the rate of financial innovation will slow for some period as investors grapple with the memories of poor financial product outcomes and with high volatility of even plain-vanilla financial instruments;
  9. Perhaps most important, consensus portfolio management philosophy will be subject to reinterpretation in a world where inter-asset class correlations have been rediscovered to be disturbingly high. For instance, allegiance to long-term equity return supremacy, spread-sector allocation maximization, alternative asset classes as a magic absolute return generator and even alpha/beta separation will be rethought.




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