According to a Fitch survey of European fixed-income investors1 overseeing about US$7.1 trillion of assets, 2011 saw a major reallocation of cash from sovereign to corporate bonds. For example, the year saw a total outflow from euro sovereign bond funds of €33 billion, as investors became increasingly concerned about the ability of European governments to solve the sovereign debt crisis. The anti-sovereign, pro-corporate bond trend is set to continue this year, the survey’s respondents told Fitch.
In recent years, investors have also been making increasing use of indices to manage their bond investments. When the first corporate bond exchange-traded fund (ETF) was launched by iShares in the United States in 2002, there were only a few fixed-income ETFs, whereas there are now more than 70 based on corporate bonds alone. According to the ETF Industry Association2, bond ETF assets grew from about US$129 billion in 2010 to nearly US$180 billion at the end of last year: an impressive growth rate of 39.5%, compared to the 5% overall growth of the ETF industry. Furthermore, bond ETF inflows reached US$45 billion (38% of the industry’s total inflows). These numbers convey the recent increase in interest in passive investing in this asset class, but only recently have practitioners and academics begun to discuss the qualities of the indices underlying such funds.3
The bond indices offered by existing providers face a number of challenges. The major one for standard corporate bond indices, which simply weight the debt issues by their market value, is the so-called “bums’ problem” (Siegel 2003). This is the result of the large share of the total debt market accounted for by issuers with substantial outstanding debt. Market-value-weighted corporate bond indices will thus have a tendency to overweight bonds issued by highly indebted companies. It is often argued that such indices will thus give too much weight to riskier assets.
This is a problem not just for individual bond issues, but also for market sectors as a whole. While it is debatable whether debt-weighting really leads to overweighting in the most risky securities4, it is clear that market-value debt-weighted indices lead to more concentrated portfolios, something that conflicts with investors’ desire for a diversified portfolio. Barclays Capital, for instance, aims to limit such concentration in one benchmark by capping issuers’ weights to a fixed percentage of the index and then redistributing the excess weight across the other issuers (the Barclays Capital U.S. Corporate Aaa-A Capped Index is market-cap weighted with a 3% cap on any individual security’s weighting).
In addition to the problem of concentration, fluctuations in risk exposure, such as duration or credit risk, are pronounced in existing indices. Such uncontrolled time-variation in risk exposures is incompatible with investors’ requirements that these exposures be relatively stable, so that allocation decisions are not compromised by implicit choices made by an unstable index. Liquidity is also a concern. The recent EDHEC-Risk European Index Survey5 shows that, for corporate bond indices, 68.3% of respondents regard liquidity risk as an important or very important issue, while only 2.4% do not worry about it at all.