Morningstar - Fall 2019 - 32

Spotlight: Bonds

While those tools were undeniably valuable
to many of the institutions they were designed to
serve, they didn't always jibe with the way
that individuals and advisors think about investing.
Further, bond index families as a whole were
daunting for the average investor or financial
advisor to sort through and select from. Given their
breadth and complexity, many lacked clear
and self-evident family-level organization.
Indexes within the same family, for example, often
overlapped each other. And their names
were confusing. Terms such as "aggregate,"
"multiverse," and "universal" were used
interchangeably, and maturity tenors were
expressed in both words ("short-intermediate")
and numbers ("1-7").
That was problematic, because bond benchmarks
play a critical role in structuring, defining,
and shining a light on the fixed-income market
in ways that are simply less necessary for equities.
Indexes also serve a democratizing function.
In the words of Mahseredjian and Friebel: "Indexes
make the bond market more efficient by
eliminating the information advantage formerly
held by a few."2
The bond market needs structuring because
it is far broader, more layered, and more fluid than
the stock market. In addition to corporate
issuance, it includes debt from governments and
municipalities, and a vast range of securitizations
with different rates, maturities, and cash flow
structures. Old bonds are always maturing,
while new bonds are coming to market, often from
the same issuers. Thus, bond indexes must
rebalance more frequently than equity benchmarks
in order to capture new issuance and bonds that
are called or maturing.
The over-the-counter nature of bond trading also
presents challenges. In the absence of
a central exchange and with many bonds not
trading regularly, liquidity is a perennial concern.
Pricing data can be difficult to obtain.
"Transparency" is a term rarely associated with
the bond market-or for that matter, the
bond index providers.

Indeed, the broad provision of information was
never the goal of the traditional bond index
providers. Underlying index composition and data
were difficult to obtain or cost-prohibitive.
Yield and basic return information were often
the only data made available.
While regulators often require funds to release
their holdings at regular intervals, no such
requirement exists for the indexes against which
they're benchmarked. An investor without
access to underlying data for the index against
which her portfolio is managed, therefore,
may not know that her investment's risk profile is
different from that of the broader market on
parameters such as sector allocation, credit quality,
and interest-rate sensitivity. A fund can sport
an exceptionally high yield or outperform
because of a large bet on bonds with low credit
quality or local-currency emerging-markets
debt, but it's important for investors to grasp the
risk of those bets reversing course during
different market conditions.
Banks Aren't What They Used to Be
Changes in the banking world have been myriad,
and the stuff of headlines, ever since
regulators stepped in to rescue the industry from
complete collapse in 2008, and then later
addressed scandals like the manipulation of the
London Interbank Offered Rate in 2014.
Policymakers in the United States and Europe
imposed a host of new regulations to prevent
banks from bringing down the global economy in
the future. Capital requirements have been
raised, assets ring-fenced, and bail-in mechanisms
created. Surviving investment banks converted
to commercial banks. Others were sold in
a hurry at distressed prices. The once-dominant
Lehman Brothers filed for bankruptcy.

That altered the calculus of relationships, profit
margins, and business strategies across
swaths of the industry, putting large index arms of
investment banks onto their back burners
and eventually leading to spin-offs of those groups.
Now more independent of banking and under
pressure from investors more reliant on indexes

than ever, bond index providers have begun
to refine index design and construction to align
with best practices focused on investors.
Challenge Continues
The bond market has long been the backbone of
the global financial system and economy.
Today, it is broad, diverse, and constantly in
motion-and fundamentally different than it was
before the global financial crisis. Bond indexes,
which have a critical role to play in defining
the investable universe for fixed-income securities
and serving as benchmarks for managed strategies,
give us a view of how the market has changed.
We can see that massive global stimulus in
response to the financial crisis and low interest
rates have led to an increased supply of developedmarkets government debt and lower-quality
corporate issuance in the market.

Meanwhile, investor capital has increasingly
flowed into passively managed fixedincome strategies. Investment banks, which ran
the biggest bond trading desks while also
maintaining bond indexes-a model riddled with
conflicts-have seen their role diminished.
These recent events have elevated the stature of
the bond index. Providers are now in the
spotlight and must continue to make indexes more
investable, understandable, and accessible to
investors of all stripes. Given aging demographics
across the developed world, bonds will become
even more important to investors. K
Dan Lefkovitz is a strategist, index products,
with Morningstar.

Morningstar Bond Refresh
Given that Morningstar's original bond index launched in
2007, and the changes taking place in fixed-income
markets, it makes sense to refresh Morningstar's index
offerings. This year, Morningstar is updating its bond
indexes in a number of ways, from adjusting methodologies
to broadening the sectors and markets included in
composite benchmarks and those provided by subindexes.
As always, Morningstar's goals are to strike the right
balance between completeness and investability and to
help shine a light on the market for investors.

2 Mahseredjian, V. & Friebel, M. 2004. "Fixed-Income Benchmarks." In Active Index Investing. Edited by Steven A. Schoenfeld, (New York: Wiley).

Morningstar Fall 2019

Morningstar - Fall 2019

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