An increase in corporate credit spreads has attracted net inflows into corporate bonds in recent months. Yet constructing or selecting a suitable benchmark for corporate bond portfolios poses a number of challenges. The constraints are part of an ongoing study by David Schröder of the Edhec Risk and Asset Management Research Centre.

One of the problems of corporate bond indices is the duration mismatch between issuer and investor. “The duration structure of outstanding bonds reflects the preferences of the issuers in their aim to minimise the cost of capital,” notes Schröder. “This minimisation is fundamentally opposed to the interest of investors, which usually try to maximise returns.” In Benchmarks and Investment Management, Laurence Siegel, Director of the CFA Institute, concludes that the choice of duration is an active asset allocation decision which should not be left to an index. An alternative approach would weigh different index constituents by their duration, favouring corporate bonds with a high- term-to-maturity for pension funds that have longer time horizons. Using such an approach would achieve a higher stability in terms of duration over time.

The effectiveness of a corporate bond index may also be limited by the so-called bums problem (Laurence Siegel, 2003). The bums problem refers to a large amount of outstanding debt issued by a company which adversely skews the composition of a market cap-weighted corporate bond index. As a result, indices that are capitalisation weighted (as most are) tend to be over-invested in riskier fixed-income securities. An alternative to cap-weighted indices are equally-weighted indices which attribute the same weight to all issues that are eligible for inclusion in the index composition.

Equally-weighted indices

Equally-weighted indices provide a number of advantages. They are easier to calculate since there is no need to keep track of the outstanding amount of debt issued by a company. “They also reduce the bums problem that capitalisation-weighted indices are exposed to since equal weighting automatically limits the exposure to large debtors at greater risk of default. However, if debtors not only have larger issues compared to other borrowers, but also different tranches of debt, the bums problem is still relevant.”

Constant changes in bond prices present another challenge as equally-weighted indices have to be rebalanced at regular intervals. “From a pure index calculation perspective this is not an issue,” says Schröder. “However, if the index is used as a basis for bond portfolio investments, ongoing reshuffling can provoke significant transaction costs, thereby reducing overall performance.”

Lastly, investors must ask whether a corporate bond index is suitable to meet their objective: does it provide a meaningful performance benchmark or reflect the investable universe of the portfolio manager? Will it be used to hedge future liabilities or protect the pension fund from declining in value? “Broad corporate bond indices are rarely a good benchmark for investors. Investors should carefully select corporate bond indices and closely monitor their behaviour over time."

Returns of four bond indices

Edhec compared the daily and long-term data set of four important corporate bond indices starting from January 1997. With the exception of Dow Jones which consists of 96 equally-weighted corporate bonds, the three indices (Lehman Brothers/Barclays, Merrill Lynch/Bank of America and Citigroup/Salomon Smith Barney) are market-cap weighted. Over the long-term, they generally exhibited similar risk and return characteristics: annual returns ranged between 5.52% (Citigroup) and 6.13% (Dow Jones) while annual volatility ranged between 6.28% and 6.87%. One possible explanation of why Dow Jones provides higher returns is due to its higher average duration. However, the findings show that on a daily basis returns can deviate by almost 2%. This can be explained in the context of temporary differences due to different pricing sources, notes Schröder. For rarely traded bonds, prices are not available, nor are they reliable.

With the financial crisis, the correlation of the indices declined and they have seen a wider dispersion in returns of more than 4% per day. Differences in industry segmentation and the credit quality of the index constituents may also help explain the dispersion in returns. Edhec also looked at the sub-sectors of the corporate bond indices such as financials where there are more significant variations in returns partly because the Dow Jones Index has a 33% weighting in financials.

“Mark-to-market is certainly a challenge for bond indices,” notes James Rieger, vice president, Fixed Income Indices at Standard & Poor’s. “Does one use a trade price, and if so, when was the bond last traded? How much of the security traded? Is it a dealer quote? There are more than three million fixed-income securities in today’s market place. With that we have to look at the liquidity of different sectors and issuers. Debt securities also have different structures.”

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