Recently, index providers have launched a number of alternative indices to try to address these concerns, and a variety of new approaches to index construction is now on offer. However, many of these approaches were first applied to equity indices and not designed for the bond markets per se. Despite this, index providers have started to apply the weighting principles from alternative equity indices to corporate bonds.
In this article, we examine two corporate bond index methods that use non-traditional weighting schemes. We then discuss the credit, interest rate and liquidity risks that investors face when investing in corporate bond indices.
NON-STANDARD CORPORATE BOND INDICES
An overview of corporate bond indices shows that market-value-weighted indices dominate index providers’ offerings. In the bond index universe, use of alternative weighting schemes is quite new and the recent crises in both corporate debt markets (especially for financials) and sovereign debt markets have drawn increasing investor attention to indices which offer less concentrated exposure to highly indebted issuers.
Equal-weighted index approaches seek to eliminate excessive concentration in individual index names. There is also no need to calculate issuers’ outstanding debt (which can at times be difficult6). Equal-weighted indices, however, face periodic rebalancing, resulting in elevated transaction costs, something that can be a particular problem in less liquid areas of the bond markets. However, equal-weighted indices are popular as (based on backtests) they have been found to have superior returns to capitalisation-weighted indices in several asset classes. Equal-weighting is also the naïve route to constructing well-diversified portfolios. Demiguel, Garlappi and Uppal (2006) find that 1/N equity portfolios have better returns and Sharpe ratios than capitalisation-weighted portfolios, based on studies in many different markets. Campani and Goltz (2011) show that the Dow Jones equally weighted corporate bond portfolio had higher Sharpe ratios than standard cap-weighted indices covering this sector.
Another popular weighting scheme, fundamental indexation, applies index weights based on a set of firm-level characteristics. The main objectives of this index approach are higher risk-adjusted performance and avoiding exposure to more indebted companies. In early 2012 Research Affiliates and Ryan partnered to launch a US corporate bond index series based on four company characteristics (five-year average cash flows, dividend payments, book value and sales). Research Affiliates and Citigroup have partnered to launch an alternative weighting scheme for sovereign bond indices based on another set of fundamental measures (GDP, energy consumption, population and rescaled land area).
Arnott et al. (2010) found that a fundamental index portfolio of investment grade bonds had historically outperformed a standard, capitalisation-weighted index by 42 basis points per annum. In less liquid markets like high-yield and emerging market bonds, annual outperformance was more pronounced (at 260 basis points and 143 basis points, respectively). How these indices will perform outside the back-test period remains to be seen. It is also apparent that, as the choice of fundamental criteria has a direct impact on the index performance, a set of fundamental parameters may be chosen a posteriori to lead to higher returns in the back-testing of the index.
Fundamental weighting approaches face another challenge in that some fundamental data is not accessible, since a number of bond issuers are not listed corporations (Arnott et al. (2010) recover only 84% of the accounting data for the US corporations included in their reference bond index). The decision not to include in the index those issuers for whom accounting data is unavailable obviously introduces a bond selection bias by comparison with standard, capitalisation-weighted bond indices.