Ten Questions With Jack Malvey

April 20, 2009

Jack MalveyJack 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:

  1. As mandated by regular compliance reviews, trader-index pricers and index production were separate and distinct groups with different reporting lines;
  2. Trading desks and index production did not share technology;
  3. 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
  4. 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.

 

 

 

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.

 

 

 

JoI: Should investable fixed-income benchmarks undergo any changes in light of our experiences in the last six months, and if so, how?

Malvey: Consistent with the natural evolution of global capital markets, index rules gradually change through time to better capture market reality. Since 1997, Lehman (now Barclays Capital) has conducted annual Index Advisory Councils on three continents (North America, Europe, Asia) to consider possible index modifications like liquidity, asset class additions/deletions and index analytics/technology. Biannually, these three groups, totaling nearly 100 major institutions of all classic types of debt investors, assemble for a Global Index Advisory Council.

Undoubtedly, the events of 2007–2010 will spawn vigorous council debates. In my view, major changes in the multidecade philosophy underlying broad macro benchmarks like the U.S. Aggregate Index, U.S. Universal Index, the Euro-Aggregate Index, the Global Aggregate Index and Multiverse Index will not be forthcoming. These indices were designed to be the broadest gauges of overall market performance and have well satisfied this function during this tumultuous period. This does not suggest nonresponsive index philosophy rigidity and by no means precludes a vast scope for index innovation over the early 2010s. But this innovation likely will be found mainly in the field of customized indices.

Every major capital market correction justifiably augurs a review of methods. The “great corporate governance fiasco” of 2001–2002, made infamous by Enron and WorldCom, led to the introduction of a suite of issuer-constrained investment-grade, high-yield and broader macro indices. Given that most customized indices emanate from a desire to reweight components to better reflect desired portfolio objectives and constraints, the experience of 2007–2010 will probably lead to further investigation of new index-weighting schemes. For instance, given the bold increase in world government bond supply, will investors want to be dragged by the gravitational pull of indices into portfolios with higher-and-higher weights in government bonds that offer lower returns through time? As in the equity arena, many debt investors share a basic discomfort with classical market-weighted indices.

Unfortunately for the discomforted, a broad consensus does not—and likely will not soon—exist on a satisfactory alternative to market-weighted bond indices. This lack of consensus surely will not impede ongoing experimentation through customized index channels to complement­—and perhaps someday very far in the future supplant—market-weighted indices.

JoI: What are the biggest issues facing the fixed-income market?

Malvey: On the tactical side, the global capital markets of 2009 will be centered on defining the economic trough, timing the accompanying valuation bottom for risky assets, searching for liquidity in a milieu of de-leveraging and consolidating broker-dealers, fretting about the inevitable government bond supply bulge-induced escalation of world yield curves to the detriment of absolute bond returns, and questioning the durability of concurrent U.S. dollar stability, and U.S. and non-U.S. budget-deficit expansion beyond world economic normalization.

On the strategic side, capital market professionals will be focused on the anticipation and implementation of new strategies in the face of major alterations in the legislative, regulatory, judicial, institutional, consumer, investor/broker-dealer model, and asset management philosophy frameworks. Early anticipators and adapters to this new and rapidly changing environment will have an inherent competitive advantage. As already shown in 2008, static financial organizations with nondynamic business philosophies face the highest risk of obsolescence and even extinction in a generation.

JoI: Does it make sense to use broad benchmarks like the Lehman Brothers Aggregate Bond Index to underlie investable products?

Malvey: As shown by the success of investable products like ETFs hinged to the U.S. Aggregate, U.S. Treasury and U.S. Treasury Inflation-Linked securities, broad bond benchmarks have met an essential need both from institutional and individual investors seeking to easily replicate the return/risk of key debt markets. Ahead, consideration should be given to the use of even broader macro benchmarks like the Global Aggregate Index and the Multiverse Index to mimic the performance of the entire world bond market. And boring in from the micro direction, there are dozens of potentially worthy narrower investable products that might be constructed from the hundreds of global debt index components. The beta replication of narrower index components (i.e., CMBS, corporates, Japanese RMBS, etc.) can free up total return bond managers to concentrate on their alpha-generating areas of expertise (i.e., currencies, curves, spread-products, asset allocation) in their quest to outperform formidable bond indices like the Global Aggregate Index.

JoI: Will the future of fixed-income indexes be more aligned with benchmarking/asset management or with the creation of tradable, investable products?

Malvey: The provision of accurate benchmarks for asset managers and the construction of tradable investable index products are not mutually exclusive. A strong index franchise should be able to undertake both pursuits simultaneously. If pushed to prioritize—and perhaps reflecting the thrust of my index tenure at Lehman—I would lean toward the supply of worthy benchmarks for asset managers. This is a nontrivial task. On the threshold of the second decade of the 21st century, the world bond market has not been fully mapped. A heavy emphasis on the creation of tradable index products could detract from properly resourcing the original classic benchmark function. And if not handled properly, the mix of benchmark provisioning with tradable investable index products could invite conflict conjectures from third parties. Finally, as alluded to above in your “aftermath question,” the impetus for innovation, solutions and structured products might well be dormant for an extended stretch until global capital markets fully recover and all the painful recent lessons are fully digested.

JoI: What do you see as the key trends to watch going forward in fixed-income indexing?

Malvey: At root, all asset class indices are measurement tools intended to provide institutional and individual investors, consultants, issuers and academics with a set of objective performance standards. Consistent with this guiding principle, the following trends in debt indexing may be observed over the next decade.

First, the world index map needs to be completed on a single-index platform in order to house a full measure of world bond market performance as has long been available for the global equity asset class. There are missing pieces, like an Islamic bond index and several worthy emerging-market local currency government and spread-sector markets. The creation of stand-alone indices for CMOs and certain types of structured product might be revisited. A suite of “real” indices (nominal return minus local inflation rate), an environmentally friendly “green index,” and a “socially responsible index,” might be helpful information tools. Insurers and plan sponsors might find constant portfolio (such as a book yield index) and constant duration indices useful.

Second, as investable ETFs proliferate, and as demanded by equity exchanges, bond index providers need to migrate to the standard long applied in equity markets—namely, real-time pricing.

Third, and consistent with the quest toward creating new index products, the next generation of debt index innovation might include more cross-asset combinations featuring elements drawn from debt, equity and commodity asset classes.

Fourth, while the number of broker-dealer index providers may shrink given stress-induced consolidations, behemoth global bond managers may be incented to create their own suite of specialty indices.

Fifth, like everything else in financial markets, additional regulatory oversight in some form would not surprise.

Sixth, the components of macro indices will be expanded. The eventual full convertibility of Chinese and Indian currencies will render their debt eligible for inclusion in the Global Aggregate Index and spur increased international demand for their securities.

Seventh, new product innovation will not lay fallow forever. The 2010s surely will see new portfolio management strategies accompanied by more debt ETFs, customized indices, liability-driven benchmarks and specialty-structured indices.

Eighth, recognizing that index mastery can often deliver persistent alpha in the bunched realm of competitive debt asset management performance, professional index specialists will be included on the asset management committees of first-tier asset management firms.

Overall, the further development and application of bond indices will be one of the most exciting and fastest-growing areas of finance over the coming decade.

 

[Editor's Note: The Lehman indexes are now managed by Barclays Capital.]

 

 

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