The global fixed-income market dwarfs the global equities market, weighing in at roughly $91 trillion in debt outstanding at the end of 2010. That’s nearly double the almost $52 trillion in market capitalization represented by the world’s equities,1 and it is tied to a much more diverse universe of issuers that extends well beyond publicly listed corporations. When viewing such a vast landscape, the value of establishing a method for classifying the individual issues that it comprises is obvious.
The role of an index provider extends well beyond the calculation of a total return for a given market or asset class. The index provider also gives market participants a standardized framework for segmenting an asset class along multiple dimensions to help investors better evaluate and quantify drivers of market returns, sources of portfolio performance and other market risk characteristics that may shape a portfolio allocation strategy.
Classifications are central in both the design and calculation of an index. At the very highest level, broad classifications help define the initial investment-choice set measured by an index. Once that universe is specified, narrower classifications are useful as a means of defining, isolating and representing the systematic risk factors and return characteristics of the market being measured. Finally, at the most granular level, classifications define peer groups that enable direct comparisons of similar securities.
For the fixed-income asset class, the primary dimensions used for index classification are: sector of the issuer; credit quality of the underlying bonds; currency of a bond’s cash flows; and country risk of the issuer. We will discuss the framework used by Barclays Capital to classify the fixed-income markets along these dimensions and highlight some of the applications of these classifications in the portfolio management process. We will also offer examples of the “gray areas” that arise when trying to classify a security or issuer that could fit in multiple categories.
Characteristics Of A Good Classification Scheme
The characteristics of a good index classification scheme mirror those of a good index. It must be: representative of the market being measured and how investors segment the market; transparent, with rules-based criteria; and specified in advance for index users.
In addition to these characteristics, a useful classification scheme should be hierarchical where necessary, allowing varying degrees of granularity for investors to segment a market. Different buckets within a classification scheme should be well populated with securities exhibiting similar risk characteristics for useful comparisons within and across specified peer groups. Finally, a classification scheme must also be dynamic, and managed in a way that allows it to evolve to reflect structural changes and product innovations in the market being measured. As new security types are created or as existing niche markets evolve into larger mainstream asset classes, an index classification scheme must also properly categorize these securities if they exhibit different risk characteristics or are viewed as a separate investment allocation by investors.
Sector Classification In Fixed-Income Indices
Issuer/sector classifications that categorize bonds by industry, government affiliation or some other grouping of ultimate parent/issuer risk are the basis for many key decisions made in the portfolio management process, including benchmark selection, asset allocation, security selection and risk budgeting. Granular by design, sector classifications are hierarchical and allow for comparisons and performance attribution to be made across sectors and also within a specific sector peer group.
The Barclays Capital sector classification scheme is a widely accepted standard adopted by investors who benchmark against flagship Barclays Capital Aggregate benchmark bond indices or one of its sector-based subcomponents.2 While other equity sector classification schemes focus on corporate issuers, the Barclays Capital sector classification scheme is designed to reflect the large universe of noncorporate securities that comprise the global bond market investment choice set. In addition to corporate bonds, this universe includes central government sovereign/Treasury bonds, government-related or quasi-sovereign bonds, and securitized bonds backed by a pool of assets rather than the unsecured credit of an issuer.