Bringing Clarity To The Bond Market

February 22, 2011

Bringing Clarity To The Bond Market

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.

At the first level of the Barclays Capital sector classification scheme, all issuers are classified into one of four broad sectors:

  • Treasury
  • Government-Related
  • Corporate
  • Securitized

Within these, up to three additional layers of classification exist depending on the depth and heterogeneity of issuers within that market. An example of the complete classification scheme is shown in Figure 1 using the Barclays Capital Global Aggregate Index as an example. For each level of the classification, the figure shows the number of issues, market value, index weight, average duration, average yield and largest issuers within each sector.

The following sections highlight the different classifications used at the second, third and fourth levels within each broad Barclays Capital sector.

 

Figure 1

Figure 1

Treasury (Class 1)
The Treasury sector includes native currency sovereign debt issued by central governments. These bonds are backed by the full faith and credit of a central government and represent one of the largest, most liquid segments of the global bond market. The Treasury sector is not further subdivided, though index users will normally use additional classifications by country, currency or maturity when evaluating this sector.

Government-Related (Class 1)
The Government-Related sector groups all issuers with governmental affiliations in a single category, separate from the Treasury and Corporate sectors. The Government-Related sector has four subsectors to group different types of government-related issuers: Agencies, Sovereign, Supranational and Local Authority. In the case of Agencies (Class 2), there is a further level of subclassification at the Class 3 level.

  • Agencies (Class 2)
    This broad category, sometimes referred to as quasi-sovereigns, is designed to capture all issuers that are owned by government-related entities or sponsored by government-related agencies, or whose payments are guaranteed by governments. The three subclassifications under agencies are:

    • Government Guaranteed (Class 3)
      Issues that carry direct guarantees of timely payment of interest and principal from central governments. Government ownership is not a factor, although most entities will be government-owned. Sample issuers in this category include KfW, Deposit Insurance Corp. of Japan, Canada Housing Trust and Radio Televisión Española.
    • Government Owned, No Guarantee (Class 3)
      Issuers that are more than 50 percent owned by government-related entities but that carry no guarantee of timely repayment fall into this category. Ownership includes all direct central and local government ownership as well as indirect ownership through other government-owned entities. It also includes state-owned entities that operate under special public sector laws. Entities that are less than 50 percent government-owned go in the appropriate corporate bucket, unless the entity fits the definition of government-sponsored.
    • Government Sponsored (Class 3)
      Entities that are not 100 percent government-owned and that have no guarantee, but that carry out government policies, and benefit from “closeness” to the central government. Evidence of closeness includes government charters; government-nominated board members; government subsidies for carrying out “social” policies; provisions for lines of credit; and government policies executed at subeconomic rates, with accompanying economic support from the government. Global Aggregate Index issuers in this category include Fannie Mae and Freddie Mac.

  • Sovereign (Class 2)
    This sector contains debt issued directly by central governments, but denominated in currencies other than the governments’ domestic currencies. Because of the issuer’s foreign currency risk, investors often classify these bonds separately from Treasury debt.
  • Local Authority (Class 2)
    In addition to directly issued local authority debt, this sector also contains debt sold by entities 100 percent owned, but not necessarily guaranteed, by local authorities. Debt sold by an entity less than 50 percent owned by a local authority will go in the appropriate Corporate bucket. In the U.S. market, a significant portion of this sector comprises taxable municipal bonds, including Build America Bonds (BAB).
  • Supranational (Class 2)
    This sector is meant to cover international organizations whose influences extend beyond a specific nation. Examples of supranationals are the European Investment Bank and the Asian Development Bank.

Corporate (Class 1)
The corporate classification and accompanying hierarchy is easily the largest and most detailed component of our sector classification scheme. It is a global scheme that has been developed and refined over the years to categorize issuers across geographic markets based on an issuer’s primary line of business and the revenue streams and operations that are used to service its debt. Classifications are frequently reviewed by the Barclays Capital index group in response to market events, changes in an issuer’s ownership structure, merger/acquisition, divestiture or changes in a primary line of business. New classifications may be added on an as-needed basis if a large segment of the market exhibits a well-defined risk profile that is not sufficiently categorized in the existing scheme, though these types of changes are infrequent.

Corporate sector classifications are similar in principle to the classifications used in equity indices, though they are not interchangeable. Barclays Capital bond classifications are specific to the global debt markets and will consist of peer group definitions that are different from those used in equity indices. This reflects the different market profile of the corporate bond market that also includes privately held corporate issuers.

 

The corporate sector is categorized into three broad corporate components at the second level of our classification scheme: Industrial, Financial Institutions and Utilities. Further classifications at the third and fourth levels offer investors additional granularity for cross-sector comparisons and peer group comparisons within a sector. A listing of the various Class 3 and Class 4 subsectors are detailed below.

  • Industrial (Class 2)
    • Basic Industry (Class 3)
      Class 4 subsectors include Chemicals, Metals & Mining, and Paper.

    • Capital Goods (Class 3)
      Class 4 subsectors include Aerospace/Defense, Building Materials, Diversified Manufacturing, Construction Machinery, Packaging, and Environmental.
    • Communications (Class 3)
      Class 4 subsectors include Media-Cable, Media Non-Cable, Wireless, and Wirelines.
    • Consumer Cyclicals (Class 3)
      Class 4 subsectors include Automotive, Entertainment, Gaming, Home Construction, Lodging, Retailers, Restaurants, Cyclical Services, and Textiles.
    • Consumer Non-Cyclical (Class 3)
      Class 4 subsectors include Consumer Products, Food/Beverage, Healthcare, Pharmaceuticals, Supermarkets, Tobacco.
    • Energy (Class 3)
      Class 4 subsectors include Independent, Integrated, Oil Field Services and Refining.
    • Technology (Class 3)
    • Transportation (Class 3)
      Class 4 subsectors include Airlines, Railroad, and Transportation Services.
    • Other Industrial (Class 3)
  • Utilities (Class 2)
    • Electric (Class 3)

    • Natural Gas (Class 3)
      Class 4 subsectors include Distributors, and Pipelines.
    • Other Utility (Class 3)
  • Financial Institutions (Class 2)
    • Banking (Class 3)

    • Brokerage (Class 3)
    • Finance Companies (Class 3)
      Class 4 subsectors include Non-Captive Consumer and Non-Captive Diversified.
    • Insurance (Class 3)
      Class 4 subsectors include Life, P&C, and Health Insurance.
    • REITs (Class 3)
    • Other Finance (Class 3)

Securitized (Class 1)
The Securitized sector is designed to capture fixed-income instruments whose payments are backed or directly derived from a protected or ring-fenced pool of assets (either by bankruptcy remote special purpose vehicle or bond covenant). Underlying collateral for securitized bonds can include residential mortgages, commercial mortgages, public sector loans, auto loans and credit card payments.3 There are four main subcomponents of the securitized sector: MBS Passthrough, Asset-Backed (ABS), Commercial MBS (CMBS) and Covered Bonds. Each of these is explained below.

  • MBS Passthrough (Class 2)
    Passthrough mortgage-backed securities backed by residential mortgages. This sector includes agency and non-agency issuers, but only agency issuers (FNMA, FHLMC and GNMA) are eligible for our indices.

    • Agency Fixed-Rate (Class 3)
      Six agency passthrough subsets including GNMA 30-Year, GNMA 15-Year, Conventional 30-Year, Conventional 20-Year, Conventional 15-Year and balloons (no longer index-eligible).

    • Agency Hybrid ARM (Class 3)
      A hybrid adjustable rate mortgage (ARM) is a mortgage in which the homeowner pays a fixed interest rate for a fixed period of time (typically three, five, seven or 10 years) and a floating-rate after that period, combining the features of fixed- and adjustable-rate mortgage securities. For our indices, we only track agency-issued hybrid ARMs. Within this sector there are four Class 4 subsectors for each of the major programs: 3/1, 5/1, 7/1 and 10/1.
    • Non-Agency (Class 3)
      This classification captures non-agency fixed-rate and hybrid ARM passthroughs in the U.S. as well as passthroughs denominated in non-USD currencies. Non-Agency MBS do not qualify for inclusion in Barclays Capital indices.
  • ABS (Class 2)
    Within ABS, there are Class 3 subsectors for the following collateral types, though not all are represented in our various fixed- or floating-rate indices: auto loan, credit card, stranded cost utilities, home equity loan (no longer index-eligible), manufactured housing (no longer index-eligible), student loan, whole business, and residential mortgages.

  • CMBS (Class 2)
    CMBS are securities backed by commercial real estate loans. There are no subsectors for CMBS, though other index classifications based on security type are used in this market (CMBS 2.0, CMBS Super Duper, etc.) to further segment the asset class.
  • Covered Bonds (Class 2)
    Covered bonds are recourse debt instruments that are secured by a ring-fenced pool of assets on an issuer’s balance sheet (commercial real estate, residential mortgages, public sector loans or other assets). The fact that investors have recourse to the originators is the defining difference between covered bonds and ABS issues. The category includes “structured covered bonds,” for which securitization techniques have been used to enhance the ratings of the covered bonds, but the issuing entity is usually not bankruptcy-remote. Structured covered issues are not governed by national covered bond legislation and regulation, while covered bonds are, where such guidelines exist. Pfandbriefe are classified as covered bonds under this definition.
    • Mortgage Collateralized (Class 3)
      Bonds collateralized by residential and commercial real estate, including traditional pfandbriefe, jumbo pfandbriefe and non-pfandbriefe mortgages. Danish MBS and JHFA RMBS are classified as non-pfandbriefe.

    • Public Sector Collateralized (Class 3)
      Bonds collateralized by public sector loans, including traditional pfandbriefe, jumbo pfandbriefe and non-pfandbriefe public sector loans.
    • Hybrid Collateralized (Class 3)
      Bonds collateralized by a mixture of public sector loans, mortgages and/or other assets.
    • Other Covered Bonds (Class 3)
      Pfandbriefe- and non-pfandbriefe-covered bonds collateralized by single asset classes other than real estate or public sector loans. There are two Class 4 subsectors distinguishing between pfandbriefe and non-pfandbriefe.
  •  

Sector Classifications In Practice: Examples Of ‘Gray’ Areas When Classifying Issuers In Bond Indices
Regardless of the depth and transparency of any classification scheme, there will always be situations that call for difficult decisions regarding the classification of specific issuers or types of securities. Several examples of these are detailed below to illustrate some key issues that arise in the fixed-income asset class.

Issuers Partially Owned By Government Entities
As mentioned above, Barclays Capital clearly defines the amount of ownership required in order to classify an issuer as government-related at 50 percent or more. The main advantage of this approach is that it is rules-based and there is no ambiguity around where the issuer belongs in the classification scheme. The main downside is that this definition of government-owned could place an issuer in a Government-Related bucket that some index users believe should be a Corporate. An example is the French utility Electricité de France (EDF), which is currently classified as Government-Related because it is more than 50 percent owned by the government. Some of our index users have expressed a preference to classify EDF as a corporate issuer due to its operations and the way it trades in the marketplace, but it remains classified as Government-Related based on its ownership structure. In such cases, investors may choose to use their own internal definitions if they disagree with an index classification, but our experience is that most index users overwhelmingly favor the use of objective and transparent criteria whenever possible.

Government-Guaranteed Bank Debt
One area of confusion lies in bank debt that is guaranteed by the government. Should this be classified as Government or Corporate?

In late 2008, as a result of the financial crisis, various governments passed regulations that allowed banks to issue securities whose coupon and principal payments were guaranteed by central governments. With the guarantee, these bonds were bought by both government and corporate bond portfolio managers. Immediate questions arose about the appropriate classification for these securities due to this guarantee feature. After canvassing our client base and evaluating the issue at length, it was decided the most appropriate classification was Government-Related > Agency > Government Guaranteed, to reflect the explicit government guarantee and different risk profile as compared to nonguaranteed banking debt from the same issuer. A fair amount of issuance came in this form in 2009 from issuers including Barclays, Bank of America, Citigroup and Morgan Stanley. This decision also meant that debt from a single issuer now appeared in two distinct sector classifications.

Covered Bank Bonds
As described above, covered bonds are debt obligations of the issuer secured by a designated pool of assets. The holders of covered bonds have first-priority claim to the covered pool assets that are typically residential mortgage loans. Many large banks issue covered bonds and some investors argue that these should be classified under the Corporate > Finance > Banking sector so they can be viewed alongside the other types of debt from the same bank. Barclays Capital has always categorized covered bonds within the Securitized sector separate from unsecured bank debt classified as Corporate due to claims on the ring-fenced pool of assets; this classification has also been widely accepted by our index users.

Classifications By Credit Quality
Another key classification made in the fixed-income market is based on the credit rating of a security, with a clear distinction made between investment-grade (rated Baa3/BBB- or higher) and high-yield (rated Ba1/BB+ or lower) debt. Investment-grade and high-yield portfolios are often managed separately, though portfolio guidelines may allow a certain degree of crossover, which requires a clear delineation between the two for index purposes. (See Figure 2.)

Figure 2

An added layer of complexity exists in this category because the ratings agencies used for index classification may assign different ratings to the same security. An index provider must therefore evaluate multiple ratings and then classify securities accordingly. It is imperative that index classifications based on credit quality be perfectly clear to investors because index eligibility can be affected in the event of a rating downgrade. Index users need to know not only if a security will enter/exit an index based on a change in credit quality classification, but also when that will occur.

Barclays Capital indices use bond ratings from Moody’s, Standard & Poor’s and Fitch when classifying securities by credit quality. Index classification is based on the middle rating of the three agencies, dropping the highest and lowest available ratings. If only two ratings are available, the lower rating will be used. Effectively, to be classified as investment-grade, a bond must be rated Baa3/BBB- or higher by two out of the three agencies.

Geographic Classifications By Currency & Country
Besides sector and credit quality, classifications by currency and/or country are also useful for constructing indices and comparing risk and return among various global fixed-income markets.

Currency
In its simplest terms, a bond is a promise of future payments made by a borrower to a bondholder. The currency of future cash flows is therefore the first investment decision made by a fixed-income investor when buying a bond and is a primary attribute used by Barclays Capital to construct regional benchmark indices. For example, the flagship Barclays Capital U.S. Aggregate Bond Index comprises only USD-denominated debt irrespective of the country of the issuer. It will include domestic bonds as well as Yankee bonds that are bought by USD investors.

The bond’s currency of denomination matters twofold:

  1. It determines the underlying yield curve to which the bond’s valuation will be most tied; and
  2. It determines whether the investor will be exposed to currency risk if invested in the bond.

Fortunately, the determination of a bond’s currency of denomination is generally straightforward. The bond’s prospectus and other publicly available sources will clearly state the currency of denomination of principal and coupon payments. The currency classification process may be a bit more ambiguous with “dual currency” bonds that may pay principal in one currency but pay interest in another. In this case, Barclays Capital generally uses the currency of principal payments to determine a bond’s currency. (See Figure 3.)

 

Figure 3

Country
While currency is the first consideration typically made by an investor, the country of risk of a bond is still an important input in his/her decision-making process. To illustrate, an investor will clearly value a USD-denominated bond issued by the U.S. government differently from a USD bond with similar characteristics issued by the government of Greece. Thus, we publish country subindices for many of our flagship indices as well as GDP-weighted versions of our global indices that also reference an issuer’s country.

Barclays Capital indices use a “country of risk” approach to determine country classifications. The country of risk of the issuer is determined by looking at a number of criteria, including the country providing the largest single source of sales, operations or cash flow for an issuer. In many cases, the country of risk and country of legal domicile can be one and the same, but that may not be the case for issuers that are subsidiaries of a larger parent company or that have operations in many different global locations. Country classification is generally a straightforward exercise for Treasury or government-related sector debt, but requires more detailed analysis for corporate issuers.

Defining Emerging Markets
Country and currency classifications are also useful at a broad level to categorize bonds by region or to make an even broader distinction between developed and emerging markets. Regional classifications based solely on currency are straightforward and are used in flagship indices such as the Pan Euro Aggregate or Asia-Pacific Aggregate indices.

Groupings based on more economic- or thematic-based classifications such as emerging markets are more difficult in practice. The challenge is that there is no one single and universally accepted definition of an emerging market, let alone a definition for emerging markets subdivisions such as “frontier” or “advanced.” Commonly cited definitions of emerging markets can be based on World Bank income classifications, sovereign ratings, OECD membership or other ad-hoc definitions reflecting an investor’s view of the growth or accessibility of a particular market.

Barclays Capital publishes standard hard-currency and local-currency emerging markets indices using World Bank definitions and/or sovereign ratings, the two most widely cited criteria for defining an emerging market. However, with our broad market coverage and index customization capabilities, investors often construct benchmarks based on their own internal definitions of emerging markets.

Other Notable Fixed-Income Classifications
Other common classifications made in fixed-income indexing include the taxability of a bond’s cash flows, coupon payment types and the priority of claims that a bondholder has in an issuer’s capital structure.

Taxable Vs. Tax-Exempt Bonds
In the U.S. bond market, a clear distinction is made between taxable and tax-exempt (municipal) securities. Taxable and tax-exempt portfolios are generally managed separately and appeal to different investor bases. Barclays Capital publishes a separate U.S. municipal bond index that uses its own classification schemes based on security type (general obligation bond, income bond, etc.) and geography (state government, local government, etc.).

Fixed-Rate Vs. Floating-Rate Vs. Inflation-Linked Bonds
Another distinction is often made based on the calculation of coupon payments for bondholders. The three main index categories based on coupon type are fixed-rate, floating-rate and inflation-linked. Separate indices are available for each type for dedicated investors in these markets. Broader indices that combine these different security types into a macro index are also available on a customized basis.

Senior Vs. Subordinated Vs. Hybrid Capital Bonds
Investors also seek further classification of debt instruments by their place within an issuer’s capital structure. Common distinctions are made between senior debt, subordinated debt and hybrid capital securities, which are deeply subordinated bonds that have both debt and equity characteristics. (See Figure 4.) More subordinated structures have a lower claim on a firm’s cash flows and will trade wider to compensate bondholders for this risk. In some cases, investors not comfortable investing in bonds with hybrid characteristics have used these classifications to exclude capital securities from their benchmark.

Figure 4

In the case of hybrid capital, a fundamental classification also arises on how to differentiate between debt and equity securities for instruments that display properties of both. As an index provider, we classify deeply subordinated instruments where cash flows are paid as interest by the issuer on a pretax basis (not as dividends) and received by the investor on an after-tax basis as a fixed-income debt instrument. Convertible securities, preferred stock and contingent capital where there is a mandatory conversion feature or dividend payment do not qualify for benchmark bond indices and are tracked separately in other indices.

Summary
No single classification scheme can fully represent the fixed-income asset class given its diversity and complexity. Investors express their views on the asset class along multiple dimensions, each requiring a robust and rules-based framework from the index provider for segmenting the index universe and providing increased market clarity. In many cases, assigning a classification is a fairly straightforward exercise based on empirical characteristics. However, there may be “gray areas” where it can be argued that a security could fit in multiple categories in even the most detailed and well-defined classification scheme. In those cases, an index provider that is close to the market must make a clear and informed decision on the most appropriate classification of a security in a timely manner. This responsibility is taken very seriously given the effect a single classification can have on index eligibility and at nearly every other phase of the investment process.

We also recognize that no classification scheme will be universal to all investors. Therefore, an important part of any index platform should be the ability to offer investors bespoke index products using derived index classifications based on standard classification schemes.

End Notes
1 Brenner, A. with J. Murray II, “World Stock and Bond Markets and Portfolio Diversity, 2010.” Asset Allocation Advisor, December 2010.

2 This article focuses on taxable bonds indices. Barclays Capital also publishes a family of tax-exempt municipal bond indices that uses its own classification scheme given the different risk characteristics of these securities.

3 Instruments such as CLOs that package other bonds into a new security are not index-eligible.

 

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