What’s the problem with bond indices?
The recent EDHEC-Risk European Index Survey, collecting views of 104 European professional investors, reveals that only around half of current fixed-income investors are satisfied with bond indices (50.9% for government bond indices and 46.5% for corporate bond indices) compared to the relatively high level of usage rate of indices (71.6% of respondents who invest in government bonds use indices and 61.1% for corporate bond indices). On the other hand, more than half of respondents who invest in fixed-income find the current bond indices problematic (52.7% for government bond indices and 56.9% for corporate bond indices).
The survey results show that the lack of stable duration and incapability to replicate the index are the most serious issues for government bond indices. Nearly 70% of respondents have considered these two issues as important or very important. These results are in line with the literature. Benning (2006) states that bond indices are “moving targets”. This refers to the fact that bond characteristics are changing over time, even for duration and credit risk exposures (see Campani and Goltz 2011 for details). This is a serious issue for investors as it implies that they cannot manage their overall risk exposures accurately due to the holding of bond indices. Furthermore, different security selection rules across index providers and pricing difficulties are also important issues to investors for government bond indices, around 60% of respondents consider them to be either very important or important.
As for corporate bond indices, liquidity risk is the most critical concern: 68.3% of respondents regard it as important or very important and only 2.4% do not worry about it at all. This is not surprising since it is more specific to corporate bond indices, as there is a natural lack of liquidity in the corporate bond market (Biais et al. 2006). The overinvestment in more risky companies which is in fact the drawback of debt-weighted indices (see Siegel 2003) is also an important issue for corporate bond indices. The lack of stable interest rate risk exposure is seen as less important for corporate bond indices (less than half of respondents think so) than for government bond indices (nearly 70% of respondents think it important). However, 56.1% of respondents see lack of stable credit risk exposure serious problem for corporate bond indices. This is not surprising, as credit risk is more important to corporate bond investors.
Overall speaking, our survey results are in line with the literature on the criticisms of bond indices. It is clear that for a vast majority of investors, a host of critical issues with bond indices remain yet to be solved.EmailSharePrint