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Indices & Benchmarks - February 22, 2013

Reactions to “A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures”

EDHEC-Risk Institute conducted a study on corporate bond indices (cf. Goltz and Campani, 2011) to analyse their construction methodologies, as well as their risk and return properties, and especially the stability of their risk exposures. Empirical analysis was performed on four US and four European indices, including market value-weighted indices, an equally-weighted index with a fixed, low number of bonds (Dow Jones Index), and a highly-liquid index, created with the specific purpose of offering high liquidity and investability (iBoxx Liquid Euro).

From the results of this study, it appeared that all corporate bond indices considered present highly unstable risk exposures over time. Higher duration instability was obtained with the two “investable” indices, i.e. the Dow Jones Index for U.S. and the iBoxx Liquid for eurozone. Thus, investors are confronted with a trade-off between investability and risk factor stability: if they choose a very broad corporate bond index, it is illiquid, but has moderate instability of risk factor exposures; on the contrary, if they choose a very liquid index, instability in risk factor exposures will be more pronounced. This counterbalancing can be easily explained by the fact that the fewer components an index is made of, the larger a given change in the index constituents will impact the index characteristics.

In addition, Goltz and Campani (2011) underlined the conflicting interest in the duration of corporate bonds between bond issuers and investors, described in the literature by Siegel (2003), and known as the duration problem. The duration structure of outstanding bonds reflects the issuers’ preference for minimising their cost of capital. In contrast, the investors’ interests are usually to try to maximise their returns. There is no reason, in principle, for these two objectives to be in line. Credit risk exposure was also identified by Goltz and Campani (2011) as largely unstable.

The fluctuations in corporate bond index risk exposures identified in the study seem to indicate that current corporate bond indices are inappropriate for many investors who seek relatively stable exposures to keep their allocation decisions from being compromised by such fluctuations.

A call for reaction based on this study was conducted in February 2012 to gain insight into practitioners’ perceptions on the issues identified by Goltz and Campani (2011).

A questionnaire of 24 questions, covering in detail the various issue points, was proposed to investment professionals. Sixty-eight responses were received, including respondents from North America (40%), the European Union (26%), the UK (17%), Switzerland (8%), and Australia and New Zealand (9%), thus constituting a diversified sample of investors. The population of respondents was made up mostly of asset/wealth managers (74%). The general conclusion was that the respondents were broadly sharing the criticisms raised by Goltz and Campani (2011).

First, it appears that only 41% of respondents are satisfied or very satisfied with corporate bond indices, which confirms the inadequacy of corporate bond indices with investors’ needs described by Goltz and Campani (2011). The responses given by practitioners reveal that several issues are seen as paramount to investors in corporate bonds and corporate bond indices.

The instability of corporate bond indices' risk factor exposures, arguably the key conclusion of the underlying paper, was affirmed by the majority of respondents. For example, between 64% and 80% of respondents agree or strongly agree to evaluate the instability of interest rate risk exposure as problematic. In addition, 45% of respondents agree or strongly agree that bond issuers and investors have conflicting interests when it comes to the duration of corporate bonds. Using derivative instruments may appear as a solution to interest rate risk instability as in principle one can create on overlay strategy that neutralises the fluctuation of risk exposures in the underlying index. However, only 57% of respondents indicate that they can use derivatives for such purposes, leaving almost half of them with no tools to manage the instability problem.

The instability of exposure to credit risk is also identified as problematic by about two-thirds of respondents. In that case, only one-third of respondents say that they would have the ability to use derivatives products to manage instability. Furthermore, nearly half of respondents recognise that there is a direct trade-off between an index’s risk factor stability and its investability, which will probably present obstacles to index providers who wish to provide indices created to be the foundation of an investment vehicle. The various issues identified for corporate bond indices may be one of the reasons for the current relative unpopularity of passive investing in the corporate bond market. As corporate bond indices should allow investors to achieve specified objectives, particularly the management of defined risk factors, it will be increasingly important for index providers to construct indices using methods which account for the stability of these risk factors.