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What Goes Into Better Bond Indexes

Morningstar is aligning bond indexes with an evolving market

Dan Lefkovitz

 

Bonds have shown remarkable resilience in the years since the global financial crisis, shaking off paltry yields, interest rates that had nowhere to go but up, the eurozone crisis, and U.S. municipal market fears. While pundits have dismissed them as return-free risks, bonds have quietly served the time-honored functions of producing income, diversifying equity market risk, and providing portfolio ballast—especially appreciated during times of market stress. 

But the landscape for fixed-income investors has evolved considerably over the past decade. Morningstar’s new white paper, “A Whole New World for Bond Investing,” details several of the fundamental shifts that have realigned the market, including: 

  • Developed market sovereign debt and lower-quality corporate issuance have proliferated as a result of government stimulus and low interest rates.  
  • Investor capital has flown from traditional active strategies to index trackers, albeit to a lesser extent than on the equity side.  
  • The investment banks that once dominated bond indexing, while also running the biggest bond-trading desks, moved to play a diminished role.  
  • Trading volume has fallen and liquidity in sections of the bond market has dried up. 

In order to simplify the processes of benchmarking and product creation against this backdrop, Morningstar is refreshing its bond index offering by launching a comprehensive suite of indexes, composed of consistent building blocks that span global markets and asset classes. The indexes strike a balance between completeness and investability, with an emphasis on liquid tradable securities. 

Learn more about what’s driving these indexes. 

The bond market is complex; bond indexes needn’t be 

The bond market is broader and more layered, and it is changing faster than its equity counterpart. Factors contributing to its complexity include:  

  • In addition to corporate issuance, the bond market includes debt from governments, municipalities, and a vast range of securitizations with different rates, maturities, and cash flow structures. 
  • Old bonds are constantly maturing while new bonds are coming to market, often from the same issuer. 
  • Liquidity is a perennial concern, with many bonds not trading regularly. 
  • Pricing data can be difficult to obtain. 

Bond indexes help define and structure this complex market. They delineate the opportunity set for investors, offer measuring sticks for active managers, and democratize information. With passive fixed-income investing growing in popularity, bond indexes increasingly underpin investment strategies. 

Yet bond indexes were historically the province of the investment banks and were never really geared to serve end investors. Whereas third-party data and publishing firms long dominated equity indexing, the banks’ near monopoly on trading data put them in the best position to create bond indexes. Over the years, indexes evolved into collections of eclectic sets of sprawling benchmarks that often lacked clear, self-evident family level organization. 

Today, with passive fixed-income strategies approaching $2 trillion in investor assets, bond indexes are critical—yet they remain difficult to replicate. In a study on the performance of bond funds, Morningstar researchers Mara Dobrescu, Matias Möttölä, and James Li assert that the complexity of bond benchmarks causes many managed fixed-income strategies to underperform: “In markets where transaction costs [such as illiquid and hard-to-trade securities, and frequent rebalancing] are particularly elevated, both active funds and ETFs have struggled to match the performance of the index.” 

Breaking down Morningstar’s new bond indexes 

In the decade since Morningstar first launched bond indexes, the market has changed—and so have the needs of investors. Though banks have receded as index providers, bond indexes have gained importance. While many issuers have taken advantage of low rates to issue bonds, turnover declines precipitously within months of new issuance.  

Morningstar’s new family of bond indexes better align benchmarks with the actual opportunity set for fixed-income investors. Features include: 

  • Enhanced investability. The indexes prioritize larger, more-liquid bonds and contain fewer constituents than peers, which minimizes tracking costs and eases tracking while continuing to reflect the contours of the overall market. 
  • Consistent organizational structure. More than 100 indexes cover key asset classes and regions, with discrete, nonoverlapping building blocks.  
  • Transparency into key exposures such as sector allocation, credit quality, and interest rate sensitivity. 

As more investors transition from the accumulation phase of life to the decumulation phase, fixed income will only grow in importance. Morningstar’s bond indexes can be a valuable addition to investors’ portfolio-construction tool kit.  

 

For more on how Morningstar’s bond indexes can provide a unique perspective on a complex asset class, download our white paper.

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