Who are fixed-income indices really serving: borrowers or lenders? Allspring Global Investments provides its view on the question.
Passive investing has been on the rise in recent years as institutional investors, including Australian superannuation funds, grow larger and face capacity constraints, while the increasing concentration in equity markets has made it harder for active managers to outperform.
But where equity indices provide investors with a way to combat at least some of these dynamics, fixed-income indices do little to mitigate risks for investors.
In fact, many institutional investors know that fixed-income benchmarks are inherently flawed since they tend to allocate the largest weight in the index to the company, or country, that is most in debt.
What is less appreciated is that fixed-income index construction doesn’t just expose investors to the more risky end of the debt spectrum, it also tends to cause risk to increase in periods of market stress, according to Allspring Global Investments.
Benchmark-driven portfolios are shaped by the needs of borrowers, not the goals of investors. Over time, … exposures shift – often in ways that increase risk and reduce return potential – leaving investors holding the bag when the music stops
In a recently published paper, “Are You Buying What They’re Selling? We’re Not – Here’s Why”, the authors pose the question of whether fixed-income benchmarks actually take investors into account or simply serve borrowers.
Their answer is clear.
“Benchmark-driven portfolios are shaped by the needs of borrowers, not the goals of investors. Over time … exposures shift – often in ways that increase risk and reduce return potential – leaving investors holding the bag when the music stops,” the authors say.
For example, in the lead-up to the Global Financial Crisis (GFC), which in part was caused by the largely unchecked expansion of the subprime mortgage market, fixed-income benchmarks, including the widely used Bloomberg Global Aggregate Bond Index (Global Agg), skewed investors increasingly more to these instruments as strong demand and loose underwriting fuelled growth.
“The allocation to securitised sectors in the Global Agg grew 14 per cent from early 2005 to late 2008, reaching its peak at the worst possible time for Global Agg-based investors,” the authors write.
Shifting Duration Profiles… for the Worst
The reservations investors have about index construction in fixed income are not limited to the higher exposures to the risky areas of the debt sector, but they also extend to the impact on the duration profile of indices, especially in how this profile shifts over time.
The duration of the Global Agg index has tended to fall when interest rates are high and increase when rates are low. This is great news for debt issuers, but not so much for investors as they benefit from receiving high interest payments for longer and seek to reduce risk by getting repaid quickly when rates are low.
For example, between 2015 and 2021, yields were low and the percentage of bonds with maturity rates longer than 10 years rose steadily, averaging about 20 per cent of issuance. But the issuance of long-dated bonds increased sharply at the onset of the COVID-19 pandemic.
“Long-bond issuance jumped, reaching a peak of 30 per cent in late 2020. This allowed borrowers to lock in low yields for as long as possible,” the authors say.
From the end of 2008 to the end of 2021, issuers exploited the low-yield environment by terming out their debt. As a result, duration of the Global Agg rose 47 per cent. This change left the index at its all-time highest duration, just as the US Federal Reserve began its most aggressive rate-hiking cycle in a generation
The situation reversed when central banks started to raise interest rates in 2022, causing long-term bond issuance to fall off a cliff.
“As yields rose in 2022 – an environment favouring lenders over borrowers – issuers pivoted to shorter-maturity debt for more flexibility and reduced long-term obligations. At one point, issuance beyond 10 years fell to below 10 per cent – the lowest in well over a decade,” the authors say.
A glance at the Global Agg shows just how much this dynamic impacted the duration profile of the index after the GFC.
“From the end of 2008 to the end of 2021, issuers exploited the low-yield environment by terming out their debt. As a result, duration of the Global Agg rose 47 per cent,” the authors say.
“This change left the index at its all-time highest duration, just as the US Federal Reserve began its most aggressive rate-hiking cycle in a generation, and resulted in the worst price declines for bondholders in the history of the index.”
When it comes to investing in fixed-income indices, the old Latin phrase, caveat emptor, holds true: beware of what you buy and understand how index construction influences the risk profile of your portfolio over time.
To read the paper ‘Are You Buying What They’re Selling? We’re Not—Here’s Why’, please click here.
This article is sponsored by Allspring Global Investments. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.