Perspectives On Fixed-Income Index Design
By Brian Upbin

As an index provider, Barclays Capital occasionally hears commentary from some observers that the only fixed-income indexes investors have at their disposal are market-value-weighted indexes and that they are flawed by design. While it is true that market-value-weighted bond indexes such as the Barclays Capital US Aggregate Index are the most widely used benchmarks for bond portfolios, this characterization of the fixed-income index landscape is overly sensationalized, given the breadth of offerings and variety of index designs actively in use by investors looking for the most appropriate indexes for their respective portfolios.

Philosophically, Barclays Capital recognizes that no single index design is universal and, therefore, offers a variety of solutions for investors. We are agnostic with regard to the index choices made by investors; our various methodologies are simply different ways of measuring the same asset class in a rules-based, objective, transparent and usable manner. In other words, “to each (investor) his/her own (benchmark).”

The selection of the “right” fixed-income index consistently boils down to selecting what is most appropriate and usable for a specific portfolio objective (for dedicated fixed-income portfolios and as part of an overall asset allocation mix). In this article, we will outline a generalized framework for investors to consider when selecting an appropriate fixed-income benchmark; touch upon the reasons why market-value-weighted indexes are so widely used by investors; and discuss common benchmarking alternatives for those who have portfolio objectives that may require an index design option other than a standard market-value-weighted index.

Framework For Bond Index Design And Selection
Common Uses for Fixed-Income Indexes

As an index provider, we come across three common uses for fixed-income indexes, each of which may influence preferences in index design.

• The most common use is as a baseline performance target or benchmark for active or passive bond portfolios. Some may think of benchmarks solely in the context of performance analysis, but usage of benchmark index data occurs at many stages of the portfolio management process including asset allocation, security selection, and ex-ante portfolio risk analysis.
• A second use for fixed-income indexes is as informational measures of market performance and risk characteristics; this information is used by a variety of functions within a firm in the development, backtesting, evaluation and implementation of investment strategies and market analysis.
• Finally, fixed-income indexes are also used as a reference for passive investment strategies and index-linked products such as ETFs, ETNs, structured notes, etc.

Defining Index Objectives
Most standard market-value-weighted indexes are suitable for any of these three use cases, but a particular investor may have a specific portfolio objective that would require a different index design. If choosing a bespoke or less widely used benchmark, an index user will implicitly address and answer a common set of questions that would allow them to select the most appropriate index.

1. What is the fixed-income index trying to measure?
   The initial question investors must address in their benchmark selection process is what universe of securities their chosen index should be measuring. Some investors feel that an index should measure the full universe of securities in their investment choice set, while others feel a narrower universe of securities is more appropriate for a specific portfolio objective. In many cases, this question will be explicitly referenced in an investment policy statement.
   
   Those arguing for broad inclusion generally feel that not investing in a particular asset class is a conscious active management decision that is an attributable source of portfolio returns and performance. Those arguing against broad inclusion often cite that the rationale that just because they can invest in an asset class does not necessarily mean they should, and that excluded asset classes or sectors should remain a tactical view rather than an ongoing strategic decision.
   
   Preferences on the scope of a chosen benchmark are also a function of the flexibility an investor has to invest in out-of-index securities and whether those investments are tactical or strategic in nature. Investors with more discretion may use out-of-index bets as a source of additional risk-taking and the main source of portfolio alpha, and may, therefore, prefer a narrower benchmark that gives more freedom to do so. Investors with less discretion may prefer a broader benchmark so they can make those same active decisions within the context of their index constraints.

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