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Page 1 of 4 In the global capital markets, fixed-income has traditionally played second fiddle to the more glamorous equity asset class. If investing were a football game, stocks would be the star quarterback, with bonds more like the good old reliable offensive lineman. On the rock scene Mick Jagger would be the equity analyst while Charlie Watts would discuss the merits of fixed-income. And on late night television it would be Ralph Kramden pitching stocks and Ed Norton defending bonds. The topsy-turvy markets of the third millennium have the underdog asset class gaining much recognition. Recent volatility in the markets and uncertainty across the geopolitical spectrum has seasoned retail investors blowing dust off the musty fixed-income investment plans that were tucked away in the basement dresser drawer. And the first question usually asked is 'what does the fixed-income asset class look like and how do I obtain bond market returns?' Similar to the equity world, bonds also have a number of well defined, unbiased bench-marks that accurately reflect general market performance. In the U.S., Salomon Brothers has published the Broad Investment Grade index for many years, and Merrill Lynch has a similar benchmark as well. But the most wide-ly used fixed-income benchmark is the Lehman Brothers U.S. Aggregate Bond Index with an estimated $1-2 trillion in assets under management. As of August 31, 2002, this index contained 6,862 individual securities totaling $7.53 trillion in market value. Major Differences Between Bond And Equity Indexes Bond indexes Bond indexes arguably are more difficult to construct than equity indexes, primarily because there is a lack of exchange-traded pricing and a high degree of constituent turnover. In equity space, all investors will agree on the accepted end-of-day price for IBM even if there are differences in opinion as to whether the price represents real value. Stock tables printed in any number of newspapers and various online data services all transmit the same end-of-day level. Similar claims cannot be made for bond pricing. The single most difficult process in publishing a bond index is the capture and verification of individ-ual bond prices for broad market indexes. While equity indexes are quoted in real time, bond indexes still are typically published just once per day. In fact, until 1989 most indexeswere quoted just once per month. Fixed-income index publication will eventually move to a real time basis; the technical capability to produce such an index already exists. Most managers are fine with once-per-day publica-tion, given current investment guidelines, but there is a growing drumbeat for smaller, less representative index 'baskets' to be priced in real time for use in derivatives trading. The emergence of fixed-income exchange-traded funds (ETFs) will help this trend. Daily prices in the U.S. Treasury, agency and mortgage markets are easy enough to obtain from the trading desk, but there are nearly 3,900 corporate bonds in the U.S. Aggregate index and these are typically the most contested prices included in the benchmark. At mid month and end of month the Lehman trading desk hand prices every security, typically on a spread to Treasury basis. Collecting these prices on a busy day does not make the index production team very popular with traders, but they are collected nonetheless. On all other days, a 200 bond set of corporate bellwethers, selected because of their liquidity and sector representation characteristics, are manually priced. Daily option adjusted spread changes of these bonds are calculated and applied across the remaining 3,700 bonds. These new spreads are then used in conjunction with the current daily Treasury term structure to calculate yields for all bonds in the index. Prices are then calculated from these specific yields. This methodology allows the index to represent daily narrowing and widening spread movements as well as changes to the yield curve. Bond prices used in index calculations represent 3:00 p.m. levels and are bid side indications. The suggestion is often made to use the most recent prices from actually captured trades. Because most bonds do not trade every day, this methodology would not satisfy the rigorous requirements for a broad index. In addition, one would need spreads against a Treasury, not an absolute price, for this information to be useful. The second major difference between bond and equity indexes is the constant change in the fixed-income universe compared to the relatively static world of equity securities. When the S&P 500 universe is updated, it is announced with much fanfare and received with great interest by investors. Changes to the Dow Industrials are practically worthy of a parade. But changes to the Lehman Aggregate occur on a regular basis due to the cyclical nature of fixed-income securities. Bonds are born and bonds die, while equities theoretically can reach immortality. The rhythm of issuance and maturation results in an average of 30% to 40% turnover in the U.S. Aggregate index per year. Investors must keep track of new issuance to make sure they do not drift far from their benchmarks. The reinvestment of cash flows from coupon and principal payments enable managers to track these trends in their port-folios. One recent example is the reduced weight of Treasury securities in the index due to the government's buyback program and diminished amounts of new issuance, although that trend has reversed of late.
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