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By Patricia Oey | 09-18-2014 02:30 PM

Non-Traditional Bond Indexes: Know the Bets They're Making

Fixed-income indexes that aren’t market-cap weighted may have some merit, but investors need to carefully study the active bets being made, says BlackRock's Matt Tucker.

Patty Oey: Hi, we're here at the Morningstar ETF Conference. My name is Patty Oey. I'm a senior analyst on the Morningstar manager research team. I focus primarily on passive strategies.

I'm here today with Matt Tucker from BlackRock/iShares. He's the head of fixed-income strategy.

First of all, we're going to talk about international bonds. What are the traits of this asset class and why would investors want to hold it?

Matt Tucker: If you think about international bonds as a category, there are probably four major ways you can slice and dice that universe.

One is by developed market versus emerging market. It's very similar to how you think about developed-market equity countries being categorized versus emerging.

And then, do you want to invest in U.S.-dollar denominated debt or local currency? There are a lot of different ways to invest in international bonds, but if you think about those four different risk criteria or categorizations, it helps map out the universe and look at the opportunities out there.

Oey: Can you talk about the traits in terms of yield and duration versus U.S. bonds?

Tucker: Talking about duration is actually a great question. When we think about what duration measures, it measures the price sensitivity of a bond to changes in interest rates. But as U.S.-based investors, we think of that as changes in U.S. rates. If I'm thinking about a local-currency bond in Europe, that bond actually is not impacted by changes in U.S. rates. It has a different duration, which is a sensitivity to changes in local rates, in this case the euro rates.

People have to think about concepts like duration very differently. If I'm an investor in the U.S. investing in a European bond or European bond fund, if I'm investing in something that has local rate exposure, I've got a different kind of duration that's hard to match up to my U.S. duration. But if I'm buying a bond from The Republic of Italy, which might be denominated in dollars, that I can think of as having duration similar to how I think about the U.S.

The yield conversation has actually become very complex. As you know, we've been in a period where, globally, central banks have been lowering rates, implementing different forms of QE. Here in the U.S. we're toward the end of the QE program. But what it's meant is that rates are very low globally across developed markets. For investors looking at international markets, there aren't a lot of options in the developed markets for yield. People have tended to look toward emerging markets and local markets as places to find yield in this environment.

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