The world’s first bond index fund was launched in 1973 by Lehman Brothers, offering individual investors an alternative to over the counter (OTC) bond transactions and actively managed fund investments. In 2002, iShares launched the first fixed income exchange traded funds (ETF), namely the iShares iBoxx $ Investment Grade Corporate Bond ETF and the iShares 20+ Year Treasury Bond ETF.
Passive investing in fixed income took its shape approximately 10 years later than the emergence of equity indices. Today, passively managed fixed income funds account for less than a quarter of all global mutual funds and only 2% of ETF assets, but is growing at a faster pace compared to the equities space, according to a report from S&P Dow Jones Indices (DJI). The compound annual growth rate (CAGR) for fixed income mutual funds was 8.6% as of end-2022, while the same gauge was 6.9% for equities mutual funds.
“The fixed income markets are on an aggregate trajectory that approximates that of the equity markets from a decade or two earlier, but with a growth rate that has in fact been higher,” the report points out.
Benchmarking bonds
Nelson Huang, director of fixed income and multi-asset product management, Asia Pacific (Apac), at FTSE Russell, said that the greatest challenge when benchmarking fixed income products is replicability. Fixed income securities are normally traded OTC, he explained to FinanceAsia, which makes pricing tracking less transparent than the equities market.
“Striking the balance between liquidity and effective market presentation is key to make a good fixed income benchmark,” he said. “The quality of evaluation prices for non-traded bonds and the selection of eligible bonds are therefore critical to fixed income products, and this is the challenging part.”
In addition, there is the high bid/offer spread of bond transactions and a high turnover that might come along with it, making it difficult to maintain a fixed income portfolio within reasonable transaction costs. The S&P DJI report echoes this view, pointing out that the minimum cost of establishing a position in every fixed income security is higher.
A third challenge traces back to the nuanced nature of bond issuances and transactions, especially in local markets, which involves local currencies, settlement convention, quoting conventions, cash flow and calendar that are different market by market, according to Huang.
These have contributed to the broader and less concentrated fixed income indices that we see today. They take into account factors including corporates’ market capitalisation, local currencies, maturity dates, third-party rating, among others. Sampling is also a common practice when benchmarking fixed income products.
Nonetheless, both FTSE Russell and S&P DJI, as mentioned above, have seen an increasing interest in fixed income passive investment over the past few years.
“Higher interest rates now put the spotlight back on the fixed income market because it gives a comparable, or even higher, yield to equities,” Huang said. He added that the FTSE Russell indices are usually more selective in terms of the outstanding amount of debt securities to ensure liquidity.
Tim Edwards, managing director and global head of index investment strategy at S&P DJI, one of the authors of the report named The Hare and the Tortoise – Assessing Passive’s Potential in Bonds, told FA that the team is anticipating a similar evolution in passive investment in the fixed income market as that in equities.
The report also reveals that 72% to 94% of actively managed funds across the globe, in US dollars and Euros, have underperformed S&P DJI’s fixed income benchmarks.
Looking at geographical locations, 2023 was a particularly good year for Australian fund managers, said Edwards. S&P DJI’s SPIVA scorecard suggests that almost three-quarters (74%) of Australian bonds funds managed to beat their assigned index, reaching the lowest one-year underperformance rate since the index’s launch in 2015. However, in India, 81% of fixed income fund managers underperformed in 2023.
Looking ahead, Edwards is hoping for greater education among investors on such benchmarked fixed income strategies, which helps take control of fixed income securities’ allocation, while mitigating exposure risks at the same time.
FTSE Russell's Huang is seeing a growing interest in bond indices that track securities denominated in local Asian currencies, along with a higher interest in investing in local fixed income markets overall.
Among them is a foreign exchange (FX) protection trend for Asian investors, a typical example of which is a combination of dynamic multi-asset and multi-currency income strategy. A composite of 30% Russell 1000, 20% US Treasury, 30% local stock and 20% local fixed income ensures both dollar and local currency income to diversify their currency risks, he said.
