(ATF) Bond indexes are a more recent financial innovation relative to equity benchmarks but their popularity has risen with the explosive growth in the bond index fund market.
These instruments not only serve as a barometer of market temperament but are also used by both active and passive fund managers.
Actively managed funds measure their performance by benchmarking themselves against bond indexes, while index trackers or passive fund managers use indices to track a market as closely as possible in an effort to replicate the index performance.
“Bond indices help investors manage the complexities of the bond market and bring greater visibility to a historically opaque and illiquid asset class,” information provider IHS Markit said in a report, adding that they offer investors an opportunity to invest in multiple liquid bonds in a single instrument. “Bond indices also allow for greater risk control by affording investors the ability to tailor their potential exposure to risk and return.”
Vanguard Group, the world’s largest mutual fund manager, launched a bond index fund in December 1986 called the Total Bond Fund, which was the first bond index fund ever offered to individual investors.
“In an environment of low yields and jittery stock markets, where do you hunt for long-term, low-cost investment strategies that offer liquidity, balanced risk and diversification? The solution, for an increasing number of investors, is fixed-income ETFs,” Vanguard analysts said.
Vanguard said the global value of bond-ETF assets had grown to over a $1 trillion from $172 billion a decade ago.
“While passive equity investment has gathered strength during that period, investors are realising that indexing works just as well in fixed income,” they said.
Liquidity – the ability to buy or sell an asset within a reasonable period of time with limited price disruption – is equally important in selection of constituents in a market which is still primarily over-the-counter driven.
“We specifically created a bond index of a low number of constituents to help increase transparency and liquidity,” Christian Kronseder, CEO of ALLINDEX AG, which constructed the Asia Times Financial China Bond 50 Index.
“It is important because about a third of the constituents trade on a daily basis and provide a good understanding of the economic activity. Too many constituents and you run the risk of illiquid bonds and the benchmark will then fail to represent the underlying bond market.”
The case for China
A critical function of bond indexes is also to provide investors a sense of the importance of the market and the extent of its development.
“The catalyst for many institutional investors to invest in China will likely be driven by index inclusion,” State Street analysts said.
Last year, China’s onshore bond market overtook Japan to become the second-largest in the world in terms of bonds outstanding, behind the United States.
“The rise of China’s bond market to become the world’s second largest has been driven primarily by local investors. The next stage of its growth should see more diverse ownership and a closer alignment with international standards, as Chinese securities are increasingly represented in flagship global benchmarks for stocks and bonds,” said BlackRock Inc, the world's largest asset manager. It said China bonds have lower correlation to different asset classes.
Bloomberg Barclays Global Aggregate Index began including China’s government and policy banks in April 2019.
JPMorgan Chase & Co. began a phased inclusion of Chinese government debt into its benchmark emerging-market indexes in February this year.
China’s yuan-denominated domestic bonds are also on the watchlist for inclusion in FTSE Russell’s World Government Bond Index (WGBI).
Global investors now own a record 1.34 trillion yuan (US$189 billion) of government bonds as of end-March, according to FTSE Russell. It said foreign holdings of Chinese government bonds reached 8.7% by end-March.
Still that is tiny when compared with developed markets such as Japan (12.1%) and the US (28%), as well as such emerging markets like Indonesia (39%) and Malaysia (24%).