New directions in passive bond investing

Antoine Lesné of State Street Global Advisors argues for an alternative to traditional cap-weighted indexes which can provide equal or greater returns with reduced risk

Most major indexes are capitalisation-weighted, ranking index constituents by size. For fixed income investors, following these indexes means allocating larger amounts of their capital to the institutions with the most debt. This capital allocation practice has become increasingly difficult to defend.

At State Street Global Advisors, we researched the alternative-weighted concept for corporate bond indexes and found that the approach can potentially achieve better index returns versus a cap-weighted index but with lower volatility. Our research contributed to the creation of a new alternative-weighted index, the Barclays Capital Issuer Scored Corporate Index (ISCI), which reweights corporate indexes in the US and Europe based on three factors: Return on Assets (ROA) and Interest Coverage or Current Ratio.

These indexes seek to maintain similar systematic sector exposure as the traditional benchmarks, but with an adjusted allocation to issuers within these sectors. They have achieved historically lower volatility and improved risk-adjusted returns.

Managing idiosyncratic risk in bond strategies
Broad market or aggregate bond index strategies have a substantial allocation to entities with considerable amounts of debt. When significant price moves occur among the largest issuers, the impact on such indexes can be dramatic, as the largest issuers will have a “disproportionate” impact on the index. This is known as idiosyncratic risk. Think of names like Lehman Brothers and General Motors and you get the idea. As you can see in Figure 1, the traditional index (the green and orange bars in the chart) includes many issuers that have very little weight in the index, while a very few issuers have far greater weight, comparatively speaking. In contrast, the ISCI index (the blue bars) substantially reduces the disparity in the weightings, more evenly distributing the weight between the index components.

Some investors may adopt an active approach, enabling them to assess a company’s financial condition and express an opinion on which bonds are more likely to default. This is not the approach followed by ISCI. Our analysis leads us to conclude that it is possible to construct an index-based portfolio that quantitatively re-weights a corporate universe by ranking or “scoring” the issuers based on the trend of a company’s financial strength. Crucially, this approach preserves all of the primary benefits of passive investing, which are transparency, cost, efficiency and diversification. In our view, ISCI does a better job of diversifying risk within the specific bond universe. ISCI does not aim to avoid issuers that score low. Rather, it seeks a broader deployment of capital among all the constituents, not simply the big ones. If the index sought to screen for only the companies that rated the best, the result would be something akin to a triple-A rated index, which is not the intent.

With ISCI, greater capital is allocated within each sector to those issuers that generate the highest financial scores in terms of improvement of their return on assets and interest coverage. From an idiosyncratic risk standpoint, the risk is more evenly distributed among the issuers than in a traditional cap weighted index. Our analysis found that issuer allocation explains the biggest difference in returns between an ISCI approach and a market capitalisation-weighted approach.

Subordinated debt is excluded

Corporate bond indexes ordinarily include debt issued by private companies, and subordinated debt. Figure 2 compares the attributes of ISCI with the market cap-weighted Barclays Capital Corporate Index – with and without subordinated debt, providing a snapshot of index compositions and yields as of 30 September 2011. Both of these security types are less liquid, and subordinated debt exhibited greater volatility – particularly during times of stress, than traditional cap-weighted bond indexes, and greater idiosyncratic risk. During the financial crisis for example, subordinated debt issued by financial companies became extremely volatile and illiquid. This has been the case during this summer also.

Additionally, it is more difficult to assess the financial health of private companies, whose debt is included in some corporate indexes. As a result, these bonds tend to be less liquid than debt issued by public companies.

Dynamics of scoring issuers on financial factors
Our research indicates that the overall sector allocation of debt represents the major sectors of the economy and how these sectors have been able to finance themselves across the yield curve. As such, we believe the yield curve exposure and overall duration of the Barclays Capital Issuer Scored Corporate Indexes will likely remain close to the traditional capweighted indices.

While the systematic exposure of ISCI is broadly similar to that of the standard indices, issuer weights within a sector are based on the drivers of returns and risk, namely: profitability, operational efficiency, leverage and liquidity. We believe that as financial ratios improve, so should the value of that specific company relative to its peers or sector. The index distils these elements into a small number of readily understandable scores, and redistributes issuers according to changes in financial ratios. These ratios are:

• Return-On-Assets (ROA), which expresses how many units of earnings are derived from each unit of asset an issuer controls. It gives an indication of how well a company is using its assets (which are funded by investor capital) to generate earnings in order to pay bondholders back.
• Interest Coverage, which quantifies a company’s ability to honour its debt payments.
• Current Ratio, a measure of the ability of a company to pay shortterm liabilities, using the liquid assets available to it.

ISCI uses ROA and Interest Coverage for the Financial and Industrial sectors, but for Utilities, the index uses ROA and Current Ratio since quantitative analysis indicates this ratio is most suitable for this sector.

Why depart from the traditional index?
Our analysis of the Barclays Capital Euro and US Corporate Bond indexes (excluding subordinated debt) found that by ranking issuers based on their financial health, investors can achieve broad market exposure with lower volatility and improved risk-adjusted returns over time, and produce some compelling results.¹

The SSgA model showed improved risk-adjusted returns and lower standard deviation versus the capweighted benchmark, including during the credit crunch that began in 2007, making a case that managing a passive portfolio against the index could provide drawdown protection in both volatile and smooth markets. The overall standard deviation for the US ISCI was 5.82 for the period, compared to 6.70 for the standard portfolio (excluding subordinated debt). Returns and volatility characteristics of the ISCI indexes were also compared to the US and European corporate indexes, including subordinated debt. The inclusion of subordinated debt lowered the index return, increased the volatility and decreased the Sharpe Ratio. In Europe, the subordinated debt effect on the index volatility and returns was even more pronounced, as subordinated debt is more common in that market.

Research has challenged the premise of efficient cap-weighting, and found that it is possible to earn equal or greater returns than a capitalisationweighted index while reducing risk. This is good news for investors who are interested in reducing benchmark relative risk.

Expanding the passive-investing toolkit
An issuer-scored corporate index expands the passive-investing toolkit by providing a solution that addresses concerns about idiosyncratic risk by re-allocating capital in an existing corporate index to companies based on trends in financial strength. We believe that their relying on a set of index construction rules helps maintain transparency in the investing process. The investment exposure can then be managed using a robust passive process, forming an effective part of an asset allocation portfolio.

We believe idiosyncratic risks will continue to rise for fixed income investors in the future. With rates again coming into historic lows, there is heightened potential for continued volatility ahead. By redistributing the weights of a corporate index based on trends in financial health, investors can potentially reduce the chances that the default of a single issuer will significantly impact their passive fixed income portfolio.

State Street Global Advisors Limited. Authorised and regulated by the Financial Services Authority. Registered in England. Registered No. 2509928. VAT No. 5776591 81. Registered office: 20 Churchill Place, Canary Wharf, London, E14 5HJ – Telephone: 020 3395 6000 – Facsimile: 020 3395 6350 – Web: www.ssga.co.uk The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

The views expressed in this material are the views of SSgA’s Global Fixed Income Beta solutions team through the period ended 30 September 2011 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

Although bonds generally present less short-term risk and volatility risk than stocks, bonds contain interest rate risks; the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.

All data is sourced from State Street Global Advisors Limited unless otherwise stated. This communication is directed at professional clients (this includes eligible counterparties as defined by the Financial Services Authority) who are deemed both knowledgeable and experienced in matters relating to investments. The products and services to which this communication relates are only available to such persons and persons of any other description (including retail clients) should not rely on this communication.

Source: Barclays Capital POINT/Global Family of Indices. 011 Barclays Capital Inc. Used with permission ©2011 State Street Corporation – All Rights Reserved

1. The analysis quantitatively ranked constituents based on the financial ratios above, ROA and Interest Coverage (or Current Ratio) and covered the period between January 2005 and 31 October 2010.