Fixed income indexing

What Is Fixed Income Indexing?

Fixed income indexing is an investment strategy within portfolio management that aims to replicate the performance of a specific fixed income market index. This approach falls under the broader financial category of passive investing. Instead of relying on active management to select individual bonds and potentially outperform the market, fixed income indexing seeks to match the returns and characteristics of a chosen benchmark. This is typically achieved by investing in a diversified portfolio of bonds that mirrors the composition of the index in terms of credit quality, maturity, and sector allocation.

History and Origin

The concept of indexing originated in the equity markets, with the first equity index fund launched in the 1970s. For fixed income, total return bond indices were first developed in the 1970s, initially measuring only U.S. investment-grade bonds. Indices for high-yield U.S. bonds and non-U.S. government bonds emerged in the mid-1980s. This period also saw the increasing recognition that many active bond portfolio managers struggled to consistently outperform their benchmarks, leading to the development and proliferation of passively managed bond index funds.

The evolution of fixed income indexing has been closely tied to advancements in market structure and transparency. After the Global Financial Crisis, changes in bond market structure and constraints on bank balance sheets contributed to a more transparent and transactable bond market, with fixed income indices becoming central to this evolution.¹² The growth of exchange-traded funds (ETFs) has played a significant role, democratizing access to bond markets that were traditionally more difficult for individual investors to enter.¹¹ Early fixed income ETFs provided broad market exposure, and newer iterations offer more precise exposures across various factors.¹⁰ For example, the Bloomberg Global Aggregate Index, a widely recognized benchmark for global investment-grade debt, was created in December 1998, with its history backfilled to January 1, 1990.⁹

Key Takeaways

• Fixed income indexing is a passive investment strategy designed to mirror the performance of a specific bond market index.
• It typically involves investing in a diversified portfolio of bonds that matches the index's characteristics.
• The approach aims to achieve market returns rather than attempting to outperform the market through active security selection.
• Fixed income indexing offers benefits such as lower costs and transparency compared to many actively managed funds.
• The growth of fixed income ETFs has significantly increased access to and the adoption of fixed income indexing.

Formula and Calculation

Fixed income indexing doesn't involve a single universal formula for "the index" itself, as an index is a theoretical construct. Instead, the "calculation" refers to how the index's performance is determined and how an index fund attempts to replicate it. A bond index is computed from the change in market prices and the interest payments associated with selected bonds over a specified period.

For a total return index, the calculation of its performance involves:

Where:

• Ending Market Value: The aggregate market value of all bonds in the index at the end of the period.
• Beginning Market Value: The aggregate market value of all bonds in the index at the start of the period.
• Accrued Interest: The total interest payments (coupons) collected from the bonds in the index during the period.

An index fund attempting to replicate this would aim for its net asset value (NAV) to track this total return.

Interpreting Fixed Income Indexing

Interpreting fixed income indexing primarily involves understanding its objective: to provide market-like returns for a given segment of the bond market. When an investor chooses a fixed income index fund, they are essentially opting for the average return of that market segment, before expenses. For instance, an investment in a fund tracking the Bloomberg Global Aggregate Index would expose an investor to a broad measure of global investment-grade debt, including treasuries, government-related bonds, corporate bonds, and securitized fixed-rate bonds.⁸

The performance of a fixed income index fund is typically evaluated by comparing its returns to the target index. Any significant deviation, known as tracking error, indicates how well the fund is replicating the index. A lower tracking error suggests a more efficient indexing strategy. Investors often consider factors such as the index's duration, credit quality, and geographical exposure when selecting a fixed income index. These characteristics directly influence the fund's sensitivity to interest rate changes and its exposure to credit risk.

Hypothetical Example

Consider an investor, Sarah, who wants exposure to the U.S. investment-grade corporate bond market without actively picking individual bonds. She decides to invest in a fixed income index ETF that tracks the Bloomberg Global Aggregate Corporate Index. This index measures global investment-grade, fixed-rate corporate debt from industrial, utility, and financial sectors.⁷

1. Initial Investment: Sarah invests $10,000 in the ETF on January 1st.
2. Index Performance: Over the year, the Bloomberg Global Aggregate Corporate Index, due to a combination of bond price changes and coupon payments, generates a total return of 3.5%.
3. ETF Performance: The ETF, which uses a sampling strategy to replicate the index, manages to achieve a total return of 3.4% before fees.
4. Sarah's Return: After accounting for the ETF's low expense ratio of 0.10%, Sarah's net return on her $10,000 investment would be approximately 3.3%.

In this example, Sarah's investment successfully mirrored the performance of the target corporate bond index, providing her with diversified exposure and market-rate returns without requiring her to analyze or select individual corporate bonds. The small difference between the index's return and her net return reflects the fund's tracking error and expenses.

Practical Applications

Fixed income indexing has numerous practical applications for a wide range of investors:

• Core Portfolio Allocation: Many investors use fixed income index funds as a core component of their diversified portfolios. For example, a global aggregate bond index can form a building block for fixed income portfolios, offering diversification across various types of debt and countries.⁶
• Diversification: By providing broad exposure to different sectors (government, corporate, securitized) and geographies, fixed income indexing helps investors achieve diversification within their bond holdings. This can help reduce overall portfolio risk.
• Lower Costs: Compared to actively managed bond funds, index funds generally have lower expense ratios, which can lead to higher net returns over the long term. This cost efficiency is a significant appeal for long-term investors.
• Transparency: The holdings of fixed income index funds are typically transparent, as they aim to match a publicly available index. This allows investors to understand exactly what they are invested in.
• Liquidity Solutions: Fixed income ETFs, which are based on indices, have enhanced the ability to transact in baskets or portfolios of bonds, improving liquidity in markets that were traditionally less liquid than equities.⁵ For instance, the U.S. Treasury market, a foundational element of the global financial system, experiences periods of varying liquidity, and index-based products can offer a more standardized way to gain exposure to this market.⁴,³ The Federal Reserve also regularly monitors and reports on corporate bond market liquidity, highlighting the importance of efficient market functioning.²

Limitations and Criticisms

Despite its advantages, fixed income indexing has certain limitations and criticisms:

• Market Cap Weighting Bias: Many fixed income indices are weighted by market capitalization, meaning they give more weight to the largest issuers of debt. This can lead to a concentration in the most indebted entities, potentially exposing investors to greater credit risk if those issuers face financial difficulties.
• Lack of Flexibility: Index funds are designed to track their benchmark, which means they cannot deviate from the index's composition even if an active manager believes certain bonds are overvalued or undervalued. This lack of flexibility can prevent them from exploiting potential market inefficiencies or avoiding underperforming segments.
• Interest Rate Sensitivity: The duration of a fixed income index can expose investors to interest rate risk. As interest rates rise, bond prices generally fall, which can negatively impact the value of a bond index fund. Longer-duration indices are typically more sensitive to these changes.
• Liquidity Challenges in Underlying Markets: While fixed income ETFs can provide liquidity, the underlying bond markets themselves can sometimes experience periods of reduced liquidity, especially during times of market stress. This can make it challenging for index funds to perfectly replicate their benchmarks or for larger institutional investors to execute trades without market impact. The Federal Reserve, for example, tracks developments in Treasury market liquidity, which can be affected by factors like interest rate volatility.¹
• New Issue Drag: Fixed income indices often include newly issued bonds, and the process of incorporating these into an index fund can sometimes lead to a slight lag in performance or increased trading costs, commonly referred to as new issue drag.

Fixed Income Indexing vs. Active Bond Management

Fixed income indexing and active bond management represent two distinct philosophies for managing bond portfolios.

The primary point of confusion often lies in the expectation of returns. Fixed income indexing explicitly aims for market returns, embracing the idea that consistently beating the market is difficult. Active bond management, conversely, is predicated on the belief that skilled managers can identify mispriced bonds or anticipate market movements to generate returns superior to the benchmark. However, higher costs associated with active management can erode potential outperformance, and many active bond funds struggle to consistently beat their chosen benchmarks after fees.

FAQs

What is the primary goal of fixed income indexing?

The primary goal of fixed income indexing is to replicate the performance of a specific fixed income market index. This means an index fund aims to achieve returns that are very close to those of its benchmark, rather than trying to outperform it.

How does a fixed income index fund select its bonds?

A fixed income index fund selects its bonds by mirroring the composition of its target index. This often involves purchasing a representative sample of the bonds in the index, considering factors like credit rating, maturity, duration, and sector weightings, to ensure its portfolio closely tracks the index's characteristics.

Are fixed income index funds suitable for all investors?

Fixed income index funds can be suitable for many investors, particularly those seeking broad market exposure, diversification, and lower costs. However, investors should consider their risk tolerance, investment horizon, and specific financial goals. They may not be ideal for investors who believe they can consistently outperform the market through active bond selection.

What is the difference between a bond index and a bond index fund?

A bond index is a theoretical benchmark that measures the performance of a specific segment of the bond market. It's a mathematical construct and cannot be invested in directly. A bond index fund, on the other hand, is an actual investment vehicle (like a mutual fund or ETF) that attempts to replicate the performance of a particular bond index by holding a portfolio of bonds that closely matches the index's composition.

How does interest rate risk affect fixed income indexing?

Interest rate risk is a significant factor in fixed income indexing. When interest rates rise, the prices of existing bonds typically fall, which can negatively impact the value of a fixed income index fund. The degree of this impact depends on the duration of the bonds within the index; longer-duration bonds are generally more sensitive to interest rate changes.