Index tracking for fixed income portfolios is growing in Europe, as the bond markets continue to become more diverse and more sophisticated. The fixed income arena has followed the trend for indexing as a whole, benefiting from the same sorts of advantages – in particular in terms of cost savings, as well as the latest buzzword, ‘risk budgeting’.
Among European investors, the big trend is to be interested not only in sovereign debt but also in corporate debt. Thus indices have moved away from being government-only to aggregate. This reflects a diminishing supply of government issuance, balanced by an increase in the issuance of corporate bonds. The credit market is enticing to many investors and some pension funds are attracted to index funds particularly for the ability to gain exposure to this asset class.
Numerous financial institutions are providing fixed income indices, covering varying markets and to varying specifications.
“You might have four or five companies each providing a similar index at the moment,” warns Mark Talbot, head of international bonds at State Street Global Advisors, “but only one or two will dominate in the end.”
State Street has been providing fixed-income index funds since 1995, in response to client demand. It uses a variety of index providers. “We don’t choose which to use – the client chooses. Having said that, they often ask advice.” For Talbot, key characteristics include transparency, data delivery, rules-based design and liquidity.
The biggest name in fixed-income indices, in the US as well as in Europe, is Lehman Brothers. It only provides fixed income indices and boasts the widest range in the world, offering 1,000 different indices, according to Ravin Onakan, co-head of the index group at Lehman Brothers. In the company’s own estimate, the Lehman Global Aggregate is the most widely used fixed income index. Overall, in the US, 90% of fixed income is benchmarked against Lehman Brothers, and in Europe the number is growing.
Lehman has been offering European indices since 1998, although it has been providing US indices for 28 years now. “Prior to the introduction of the Euro Aggregate Index, we had very small recognition, but now this is changing,” says Onakan. Around E200bn is benchmarked against the firm’s fixed income indices.
Lehman indices are distinguished by their high liquidity. As of January, the minimum liquidity for the European Aggregate was raised to e300m. Although there has been a slight reduction in market value, there has also been a reduced number of issues. This high liquidity is a hallmark of the Lehman European indices. “A lot of firms provide rule-based indices. But the big distinction is in minimum liquidity,” says Onakan. This rise is also in response to client wishes, he adds. “There is a perception that narrow indices are easier to track.”
“In general indices are very similar,” says Susan Ladd, global marketing director for MSCI fixed income indices. “How we distinguish ourselves is by the tools that we offer to investors. Our tools are immediately, obviously superior – that’s what our clients tell us. Our efforts go into creating the tools that our clients need.”
For example, MSCI, in conjunction with Standard & Poor’s, has launched a classification scheme for equities that is a global standard. This has now been incorporated into the bond indices, on the rationale that using the same classification scheme for both equities and bonds simplifies reporting. MSCI is also working to develop exchange traded funds (ETFs) based on fixed income indices. “They are important for MSCI on the equities side, and there is no reason we cannot have the same on the bond side,” Ladd explains.
MSCI is a relative newcomer as a fixed-income index provider. The firm offers four families of indices: global sovereign debt, denominated in local currencies, as well as three groups of credit indices, in euro, sterling and dollars. “Our aim is to span the globe and also the credit horizon,” says Ladd. The company is now in the final stages of putting together the components needed to run a global aggregate fixed income index, and is also hoping to have a range of high yield indices. “We have come late to the bond index business and are now running a solid third,” says Ladd. “And although we respect our competition, we are very determined to be number one.”
Index investing itself can be used as a powerful tool, even by investors who want to remain with active management. “Investors are approaching indices with increasingly greater sophistication,” says Rafey Sayood, managing director of fixed income research at Salomon Smith Barney. “One approach is to run a proportion of the funds tracking the benchmark closely, with the remaining element managed more actively. That way you establish an internal benchmark.”
Index funds are also useful for active managers who might want to go neutral to the market opportunistically. “Even active managers will, from time to time, not have a view.”
SSB has been providing international fixed income indices since 1981. The flagship World Government Bond Index was launched in 1986 and covers 19 major international government bond markets. “We started to provide the international indices when people had just started talking about globalisation. Since then we have been introducing new indices to reflect investor interest in new markets and new products,” says Sayood. The SSB indices have been covering European corporate credit markets since 1995.
Replicability is the key to the design of an index, says Sayood. “Indexes should be replicable – if not, then it is not fair for the fund manager.” Some tracking error is inevitable, and the fund manager needs to be comfortable with its level.
Rather than covering the full spectrum, Goldman Sachs focuses on providing corporate credit indices covering Europe. It launched a high yield index in July 2000 and an investment grade index in January 2001. “This is our focus because that’s the group we belong to,” says Fernando Cunha, head of the index group, global credit strategy. “There has been a great deal of interest after the launch of the euro in high yield fixed income investment. At the same time as government securities have been disappearing, credit is becoming the big story.”
The Goldman Sachs indices focus on the most liquid segment of the credit market. “We understand that our niche is more along the lines of a subset,” says Cunha. “One key element has been our capacity to generate meaningful numbers. You cannot price all the bonds on a high-frequency basis.” He makes an analogy with the S&P 500. “We choose a smaller number of bonds that we can price every day, giving a fresher and more accurate view of the market.”
This issue of selection is crucial to the managers of fixed income index funds. “It’s a very different ball game from equities,” maintains Partha Dasgupta, head of fixed income strategy at Barclays Global Investors. BGI is the largest manager globally of fixed-income index funds, with more than $100bn (e115bn) under management. And it tracks around 100 bond indices and sub-components.
From the user’s perspective, replicability is significant. “Bond markets are less liquid and it is in principal harder to go out and buy the bonds than it is to buy equities.” Bond managers therefore have to take a sample of the bond index, remaining as close as possible to the index, taking into account sector, credit rating and maturity. “The skill comes in how you combine bonds, how you choose your subsets,” Dasgupta explains. “And then you add value for your clients by devising trading strategies.”
Dasgupta sees exciting developments ahead in the fixed income arena. “There is still potential. For example, now credit is being seen as an asset class,” he says. “The delineation between bond markets is falling away, and it is becoming possible to devise global credit strategies.” This is part of a trend towards a broader outlook on fixed-income investment, as interest is rising in global aggregates and broader based indices. These are serious structural changes.