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Constructing and Calculating Bond Indices Authors: Brown, Patrick J. Source: Gilmour Drummond Publishing, Cambridge and Edinburgh, Great Britain Date: 2002 |
At first sight, constructing, calculating, and maintaining a bond index does not appear very difficult. After all, equity market indices have existed for a long time. Since bonds are also traded securities, transferring the method of setting up equity indices to the bond universe seems straightforward. Still, bonds are different from equities in many respects. Bond markets are much more diverse than equity markets, bonds have a fixed maturity and the market thus changes swiftly, and bond trading volumes are much lower, especially for corporate bonds. There is also relatively little academic work on corporate bond index construction. So in his book Brown provides a thorough overview of bond index construction, an overview that also reveals remarkable differences from one bond index provider to another.
In the first part of the book, Brown provides a very valuable general discussion of the purpose of bond indices--suggesting that optimal index characteristics depend on the purpose of the index. Brown distinguishes between two such purposes: market performance measurement attempts to monitor the movements of a given bond market, whereas performance benchmarks seek to reflect the returns portfolio managers could have generated in a specific bond market segment. Brown highlights that, unless the aim of a portfolio manager is to replicate the market, market performance will be different from the returns of a specific bond investment strategy.
Brown also discusses what he considers the three main categories of bond indices: all-bond indices, tracker bond indices, and bellwether indices (1). All-bond indices are meant to reflect broad market movements, including all the issues for which reliable pricing is available. Tracker indices include only a subset of the bonds in all-bond indices; they must meet criteria to be included in the index. Bellwether indices should include only the subset of very liquid securities of a market, thereby reflecting only major market trends--but easily investable.
Finally, the book provides a very detailed technical description of choosing individual securities to put in an index; it deals with the challenges posed by callables, MTNs, and commercial paper; when to include new issues, and when to drop maturing debt. It provides clear recommendations for index construction, as well as the formulas necessary to calculate key indicators of the overall index.
By explaining how to construct bond indices, Brown indirectly gives the reader guidance on how to choose from among existing indices, guidance that may well be the greatest benefit of the book. However, this book is a summary of the guidelines to fixed-income index construction as proposed by the European Federation of Financial Analyst Societies (EFFAS) and its subsidiary, the European Bond Commission (EBC). The close focus on these particular guidelines, then, is the only shortcoming of this book. Other important aspects of bond index construction not covered by these guidelines are neglected. Different bond pricing sources or alternative weighting schemes are not reflected in this work--although they too are essential aspects for constructing, calculating, and maintaining a bond index.
References:
Brown, Patrick J. (2002): Constructing and Calculating Bond Indices. Gilmour Drummond Publishing, Cambridge and Edinburgh, Great Britain.
(1) The term bellwether refers to the old practice of putting a bell around the neck of a castrated ram (a wether), allowing it to lead the herd.
