Bond Indexes – What They Are and How They Work

To understand the performance of Bond Funds, you must first understand the idea of bond indexes or benchmarks. Depending on the mandate of a fund, the goal will be to either beat a bond index, or mirror its performance as closely as possible.

Most investors are familiar with two indexes: The Dow Jones Industrial Average (DJIA) and the S&P 500.  So, to help understand bond indexes lets sart there.  The DJIA is one of the oldest stock market indexes (established in 1896) and tracks the stock price performance of 30 large, established publicly traded companies. The S&P 500 tracks the market capitalization of  500 large publicly traded companies. Both the DJIA and S&P 500 indexes are ways of measuring the performance of the stock market.

The S&P 500 is considered to be much better index (in that it does a better job of measuring the market’s performance) than DJIA for two reasons.

  1. Its a broader index. With 500 securities in the index, news that is specific to just one company will only have a small impact.
  2. Its market weighted versus price weighted.

Take two companies, one with 100 million shares and another with 50 million shares.  Next say that the price of 1 share of stock in both companies moves up by $1.  If these two companies were included in the DJIA, the $1 share price increase would have the same effect on the index for both companies.  With the S&P 500, the $1 increase in share price for the company with 100 Million shares, would have twice the impact that the $1 increase in share price of the company with 50 Million shares has.  A good index is as broad as possible, and tracks changes in value (instead of changes in price).

 

Examples of Bond Indexes

There are 100s of market indexes. Some of them focus on the entire stock or bond market, and some focus on a definable slice of the market like healthcare. Below are a few of the more popular bond indexes and what they attempt to measure.  Most bond indexes, including the ones below, are market weighted.

Barclays Capital U.S. Aggregate Bond Index – Designed to track the entire taxable US bond market.

Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index – the name says it all, this index tracks only TIPS and the only variety is the maturity dates of the TIPS included in the index.

iBoxx $ Liquid Investment Grade Index – Designed to track the most heavily traded investment grade corporate bonds.

Barclays Capital High Yield Very Liquid Index -Designed to track  the most heavily traded high-yield corporate bonds.

 

Bond indexes have several problems that stock market indexes don’t

The Dual Problems: Liquidity & Front Running

Many bonds don’t trade very frequently. They have wide spreads. How does one price a bond that has not traded in week or has a very wide spread? Essentially, no matter what method one uses it will be an estimate, which may not be close to the price of the next trade. When the iBoxx Liquid Investment Grade Bond Index was created almost a decade ago, they decided that they wanted to eliminate this problem. They included in this bond index only the 100 most liquid corporate bond issues which had tight spreads and were frequently traded.

Unfortunately, this created another problem. Traders would front-run the index. Because this bond index had so few bond issues included, traders could anticipate which bonds the Bond ETF which tracks the index (ticker symbol LQD), would be buying or selling. Thus traders could make almost risk-free profits at the expense of the ETF buyers and sellers, by buying and selling ahead of the ETF. In the end, front-running was considered a worse problem than lack of price certainty. As a result the LQD went from having 100 issues to 800 bond issues.

Most bond indexes don’t include smaller bond issues to minimize the problems associated with a lack of liquidity.  For example, The Barclays Capital U.S. Aggregate Bond Index does not include bond issues of less than $250 million. Bottom line, bond indexes don’t include smaller size issues.

Mismatch Between Fund Mandates & Index Maturity

Bonds disappear over time.  As a bond reaches maturity, it will cease to exist. Because of this there is a natural turnover built into every bond index, as bonds are removed and new ones added. However, the characteristics of the bonds being added may not look anything like the characteristics of bonds that have be removed from the index. As a result, key characteristics of bond index, such as the average maturity of bonds in the index, change every year.

Imagine training to run a race without knowing if the race is 3000 meters or 5000 meters. That is the position of many active bond managers, who don’t know at the beginning of the year the characteristics of the benchmark they are trying to beat. They have the freedom to shape the average maturity of their fund within certain limits (a typical intermediate bond fund would be a 4 – 10 year maturity) but, they only have a proximate idea about the average maturity of the index.

 

What’s the Bottom Line?

Overall bond indexes have done a good job of dealing with the unique problems they face.  In our opinion one large issue still remains for investors however which is that the name of the bond index does not give you a good idea of what’s actually in the index.  Luckily for Learn Bonds readers however we have explained just that, in our article “The Top Five Bond ETFs and the Indexes They Track“.

For more information on bond mutual funds and etfs visit the Bond Funds section here at Learn Bonds

This lesson is part of our Free Guide to the Basics of Investing in Bonds.  Continue to the next lesson here.

 

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