The duration9 of debt-weighted and equally weighted indices shows severe fluctuations over time and across indices.10 This instability has major implications: even if a particular index matches an investor’s desired risk exposure today, it may not do so tomorrow. The fluctuations in this risk exposure are incompatible with investors’ requirements that duration exposures be relatively stable to protect allocation decisions from such fluctuations.
Indeed, it is no surprise that standard bond indices may not correspond to the levels of interest rate sensitivity that investors desire. Since standard corporate bond indices simply weight the debt issues by their market value, the duration structure of outstanding bonds will reflect the issuers’ preference for minimising their cost of capital and there is no reason why this cost minimisation should be aligned with the interests of investors.11 Also, each change of composition in the corporate bond index will affect its overall duration. Newly issued bonds, for example, are likely to differ from older outstanding debt in terms of duration. In addition to changes in the index composition, it is important to keep in mind that even if the bonds in an index and their relative weights remain unchanged, the indices’ average duration will decrease over time.
Campani and Goltz (2011) show that the average durations of several European corporate bond indices demonstrate severe fluctuations over time. For instance, their results show that for the same index, duration can vary from values of four to values of about seven over a ten year period: a very severe change of interest rate sensitivity. Figure 1 shows the average Macaulay duration over ten years of the iBoxx Liquid Euro Corporate investment grade index.
One solution to such fluctuations in risk exposure would be to build an index with more stable duration. There is currently a limited number of target duration indices, covering both corporate and sovereign bonds (see Figure 2).
Amongst target duration sovereign bond indices, iBoxx has target duration indices for US inflation-protected treasury bonds (TIPS). NASDAQ OMX Iceland (OMXI), Deutsche Bank and Barclays Capital also offer target duration indices for sovereign bonds.