Study: Corporate Bond Indices Are Faulty

(November 3, 2011) — New research published by the London-based EDHEC-Risk Institute has concluded that corporate bond index construction methodologies tend to be sub-optimal.

The research, titled “A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures,” found that credit and interest rate risk exposures were relatively unstable for the eight indices examined. “This naturally has significant implications for investors’ allocation decisions and for the consequences of those allocation decisions over time,” the study stated.

According to the research — compiled by EDHEC-Risk Institute’s Felix Goltz, Head of Applied Research, and Carlos Heitor Campani, Research Assistant — there are significant differences between US and euro-denominated indices: US corporate bond indices showed higher credit risk, with longer terms to maturity and hence longer durations. Additionally, the authors concluded that investors must be aware not only of what bond indices represent but also of how such key features as risk exposures will evolve over time.

Furthermore, the research stated that as a result of shortcomings of traditional indices, new forms of bond indices have been proposed — however, these new indices have failed to address the most pressing problem with existing indices: the stability of the duration.

Last month, a survey conducted by the EDHEC-Risk Institute revealed that institutional investors and asset managers have redefined indices. European investors no longer define indices as buy-and-hold, the firm found.

According to the study, investors define passive investing as being exposed to normal returns, as opposed to abnormal returns. “For institutional investors there is a clear separation today that is no longer ‘passive investment = static’ and ‘active investment = dynamic,’ but instead between beta and alpha. Alpha assumes that we can predict the future and that we take decisions on the basis of this prediction (active view). Beta management relies on a series of systematic rules based on data from the present or the past depending on the rebalancing methods used,” Noel Amenc, Director of the EDHEC-Risk Institute, told aiCIO, explaining investors’ redefinition of passive investing.

Addressing confusion between indexing and “passive investing,” 58% of respondents said they do not think that indices should only reflect passive strategies. Respondents did however indicate that indices should not be based on alpha (75.2%), according to a release from the firm.