Fixed income and debt investing have long been cornerstones of a well-diversified portfolio. With the ETF becoming the dominant wrapper for debt investing, asset managers have used legacy fixed income indices to create fixed income products for their clients. 

However, weighting in a bond index is typically tied to the amount of debt an issuer has, not credit quality. Asset managers who innovate upon this fixed income paradigm could be at an advantage.

Why legacy bond index rules exist in the first place

To understand why fixed income indices are built the way they are, ETF product managers need to know the history of the fixed income index. 

The initial bond indices were not designed for trading. They were primarily used to  benchmark manager performance at a time when the bond market was illiquid and quite fragmented. 

Full representation vs sampling

Product developers of the past dealt with the problem in a completely logical fashion: they focused on fixed income securities that could actually be traded, implementing liquidity screens and minimum issue sizes.

To give investors access to the corporate bond market, product developers leaned into sampling instead of full representation of the debt structure.  

Learn more by reading Why your fixed income index needs an upgrade

What debt-weighting does to a corporate bond portfolio

Debt-weighting is the practice of tilting a fixed income product toward companies that have the most debt.

Traditional fixed income indices inherited some practices from equities, where market-cap weighting makes a lot of sense. For an equity ETF, a market-cap weighted index serves a crucial function. As a particular security grows in value and its prospects become harder to deny, weighting an index toward that product in theory helps investors capture that collective market sentiment. 

But fixed income is an investment in debt. Rather than tapping the collective judgment of the market, fixed income indices traditionally track toward companies that have taken on more debt. 

Taking on more debt is not a signal (good or bad) of a company’s prospects yet when a company opts to take on increased debt, it can take a bigger piece of the benchmark pie. This can be wholly unrelated to any collective market opinion about the viability and potential of the security.

The financial crisis of 2008

A great example of the failures of debt-weighting occurred in 2008.

By 2007, the financial sector accounted for over 40% of the U.S. investment-grade corporate bond universe. When the Global Financial Crisis struck and the financial sector was highly stressed, debt-weighted investors were stuck holding most of their exposure in a troubled sector.

This was not because of a market miscalculation of opportunity; but because corporate bond indices were weighted toward sectors that had borrowed more.

Learn more about debt-weighting here: The concentration trap in fixed income & the equal-weight fix

The structural fix: Equal weighting at the issuer level

Given the potential pitfalls of debt-weighting, the most clear-cut solution for fixed income indexing is equal weighting.

Equal weighting provides a host of advantages in fixed income:

• A more balanced portfolio. With equal weighting, the largest borrowers no longer dominate simply because they have issued the most debt.
• Reduced exposure to the mega-cap debt complex. Traditional benchmarks are dominated by mega-caps. Equal weighting reduces that exposure and creates different possibilities.
• More intentional index design. Because equal weighting distributes capital more evenly, it creates a portfolio that reflects index design rather than size of the debt program.

It is important for fund managers to note that, compared to a debt-weighted bond index, rebalancing and reconstitution processes in an equal-weight bond index could create more turnover. 

What a rebuilt foundation makes possible

The market that inspired the foundation of legacy bond benchmarks no longer exists. With equal weighting available as a tool to break the link between debt issuance and portfolio weight, asset managers suddenly have a host of options. Innovators in the fixed income space are already changing up their approach.

VettaFi has thoughtfully and methodically developed [a collection of] fixed income indices that meet the needs of today’s ETF issuers and investors. VettaFi’s Enhanced Yield Index Suite is built to deliver incremental yield and potential outperformance. These indices systematically tilt toward higher-yielding securities with a BBB credit rating while maintaining duration neutrality amid monthly rebalances. This allows for excess yield without introducing additional rate risk.

Over a twenty-year period, the Enhanced Yield Index offered around 33 bps more yield. When credit markets were more dispersed, the pickup was north of 75 bps. In tighter markets, the advantage is reduced to only a few basis points.

According to VettaFi’s Head of Fixed Income, Samarth Sanghavi, there are two notable costs to this approach. The first is credit exposure. Over its history, Enhanced Yield has carried roughly half a rating notch lower average credit quality due to more BBB exposure.

The second cost is turnover. Enhanced Yield turns over roughly 77% one way per year, which is higher than traditional benchmarks. Most of this is due to the yearly refresh of the issuer screen, with ordinary index maintenance accounting for the balance/remainder. 

Read more about Enhanced Yield here: What a well-built index makes possible

What to ask before selecting or licensing a fixed income index

For the past few years, active management in fixed income has taken much of the oxygen in the room. Much of this is due to the structural challenges in traditional, debt-weighted bond indices.

Issuers looking to create innovative fixed income products can use benchmarks that are designed for the modern bond market.

Here are some questions product development teams and CIOs should ask potential index partners:

• Is pricing transparent? Access to easily verifiable prices and daily updates is important.
• Does the index have a data governance plan? Regulatory compliance, oversight, and administration are a lot easier when an index has a good data governance plan to track and store data.
• Can we customize the product to our specific needs? A good index provider can rapidly create a bespoke product and iterate on it with an issuer.
• Do we retain our Intellectual Property (“IP”)? While developing and evolving a new product, it is important to work with an index partner who will let you retain your IP.

VettaFi offers a host of options for issuers looking to create modern fixed income benchmarks. 

Conclusion

Arguably, the first recorded instance of a fixed income investment dates back to 2400 BC, when a stone tablet from Nippur recorded a payment of grain with a promissory note to repay the amount borrowed, plus some additional interest.

Fixed income indices, like all tools, have been built to meet the needs of a particular moment. Updating and evolving tools is essential as new opportunities arise. Fixed income benchmarks are no different. They should evolve to meet the demands of modern investors and conform to the tools investors use today, such as ETFs. 

Asset managers who want to be at the forefront of fixed income innovation need to rethink what’s possible and explore new structures that better fit today’s evolving markets.