There is a perception among some investors that bond ETFs pose little risk; however, this is far from accurate. Bond ETFs often track the Barclays indices, a family of broadbased fixed income benchmarks first published by Lehman Brothers in 1973, when active bond investing was in its infancy.1 Fixed income products have become much more complex in the intervening years, and index providers have responded with a proliferation of subindices, custom indices and new weighting schemes.
Since an index defines the universe of securities in which a manager may invest, which index is chosen has a direct bearing on the portfolio’s risk exposures and relative performance drivers. For these reasons, investors are well served by understanding the makeup of the benchmark index for any given investment strategy, including ETFs. Essentially, investors need to know what the index actually contains in order to have a reliable view of their holdings. This is particularly important in fixed income because the benchmark indices have particular structural inefficiencies that impact the risk profile and returns of a portfolio.
OTC trading/liquidity issues
The way fixed income is traded over the counter is a complicating factor for benchmarks. The bond market is almost exclusively a dealer market: An investor buys bonds from a dealer and sells the bonds back to the dealer on negotiated terms. There are no exchanges with posted prices. As a result, many securities, especially corporate issues, are difficult to trade and price effects can be material. Larger issue size is usually a significant advantage in the execution of trades.
The OTC nature of the bond market means that periods of poor liquidity can have a meaningful impact on passive strategies, which are forced to replicate an index and therefore have to purchase bonds regardless of pricing. This effect is amplified in a low-rate environment, where every quarter point makes a difference. The reduction in dealer inventory in the wake of regulatory changes following the global financial crisis has led to reduced liquidity in some instances.
In addition to liquidity, the sheer size of broad market indices is a consideration. Tracking the indices can be difficult for portfolio managers, whether through sampling or full replication. For instance, the Barclays U.S. Aggregate Index has more than 1,000 unique issuers and more than 9,000 issues, making it almost impossible to fully replicate. This means that passive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio. For example, the iShares Core U.S. Aggregate Bond ETF contains just under 5,900 issues as of 31 December 2016.
The issue-weighted problem
The foundation of an index is its weighting scheme. The overwhelming majority of indices — both equity and fixed income — are market-capitalization weighted. This weighting scheme was originally developed for equity indices as a way to reflect the broad equity market.2 In equity indices, the market determines the weights; in bond indices, however, weightings are largely determined by issue size and debt outstanding. Bond indices are driven by how much debt a company or sovereign decides to issue and the size of the individual security issued. Consequently, investors seeking to replicate the indexPassive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio. will be investing most heavily in bonds issued by the companies and countries that are most dependent on external financing. Many may still have strong balance sheets, but there is a risk that passive bond investors could be buying the “biggest losers.” In contrast, in a market-capitalization-weighted equity index, investors typically own the “winners,” i.e., the companies that have grown in market capitalization due to their success. The issuer-capitalization methodology inherent in bond indices is counterintuitive in many respects. Investing in a bond index can result in holding the debt of the most highly leveraged issuers, with the attendant risks this poses.
Interest rate sensitivity rises
A further complication is that as yields have fallen, duration (interest-rate sensitivity) has increased for the indices, with the effect that investors are now taking more interest rate risk than they were during the global financial crisis in 2008. Exhibit 2 charts the trajectory of duration relative to yield for the Barclays U.S. Aggregate Index, revealing a notable divergence, the effect of which is a fall in the yield per unit of duration shown in Exhibit 3. The decline in yield per unit of duration indicates that investors are receiving lower compensation per unit of interest rate risk for their investments in fixed income indices.
Passive managers have to make “active” investment decisions as they decide which securities to include in their representative portfolio.