Bond indices aren't as safe as you think

IndicesInvestors should be careful before adopting a bond index as their benchmark, because these indices are more complex and may be less stable than they imagine, according to a report by the Edhec-Risk Institute.

Investors have often considered bonds a safe haven and in recent years passive investing has become a popular way to gain exposure. But, says the report, “mixing bonds and passive investment turns out to be more complex than it first appears”.

Edhec takes the example of corporate bond indices. A key problem is that the universe of bonds is larger and more diverse than that of equities. Bonds may be convertible, callable, floating or irredeemable, to name just a few types, and they have different time-to-maturities and credit ratings.  Many providers create sub-indices to try to account for this diversity.

“Designing, computing, and maintaining corporate bond indices is far more complex than doing the same for a stock market index,” says the report.

Because of this complexity, risk can vary between indices, and selecting an index can be a challenge. Edhec studied eight corporate bond indices and found that the US indices showed higher credit risk, with longer returns to maturity and hence longer durations, than the euro-denominated ones.

“A typical broad index is unlikely to be the optimal benchmark for any investor,” says the report.

Edhec also found that in the two indices with the fewest bonds, the exposure to interest rate and credit risk was more unstable.

“Even if a particular index matches an investor’s desired risk exposures today, there is no guarantee that it will do so tomorrow,” says the report. “The fluctuations in risk exposures are incompatible with investors’ requirements that these exposures be relatively stable.”

Different types of index have specific problems. Value-weighted corporate bond indices tend to be overweight in issuers that already have a large amount of outstanding debt. Because they are heavily indebted, these issuers are more likely to be downgraded or even default.

Edhec offers the example of the European telecoms sector around the year 2000, when companies financed the very high cost of UMTS licences with corporate bonds. This meant that telecoms firm took up a larger proportion of the total bond market even though their creditworthiness was declining.

Edhec concludes that bond indices must be improved before they can become as popular as equity ones.

“Passive investing will gain ground only if bond index providers begin to develop better methods of constructing indices,” says the report.

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