Indexing in Fixed Income
The global bond markets are extensive, with individual bonds all trading with their own unique terms, coupons and maturities. Individual bonds are also often illiquid or difficult to source and, therefore, not broadly available. Fixed income indices have helped standardize the bond markets, taking this largely over-the-counter (OTC) market and creating defined units. These units can be as broad as the total market or can focus on key segments like high yield or investment grade corporate bonds, mortgage-backed securities, or municipal bonds, to name a few. Indices can be further subdivided by rating band, maturity range, sector or sustainability characteristics, among plenty of other dimensions.
Fixed income tradable indices take this one step further by offering strategies that may be used as the basis for tradeable products. Fixed income tradable indices underlie financial products that take a number of forms, including ETFs, standardized total return swaps, futures and credit default swap indices. These instruments have evolved to track a liquid segment of the bond markets and offer options including diversification, investability and trade efficiency. These instruments also offer transparency, given that index construction methodologies are public and memberships for indices’ underlying fixed income tradable products are often public as well. Further, fixed income tradable indices can enhance transparency by providing a measure of continuous pricing to the bond markets.
Fixed income tradable indices are designed to provide an efficient means to measure the bond market. This primer is meant as an introductory reference for these instruments, as well as to highlight their performance in recent market periods. While some of these instruments measure similar market segments, each instrument type comes with unique features that may make it more suitable for different trade conditions.
As the fixed income tradable index ecosystem has developed, the addition of new tools has proven to be accretive to volumes across instruments (see Exhibit 1).
From Benchmarks to Tradables
The transition from broad benchmarks to liquid indices designed to underlie tradable products involves careful construction intended to select liquid index constituents. The final composition aims to reflect liquid segments of the market, while also limiting idiosyncratic risk via capping. Efficiency and transparency in the underlying index may enhance the ease of replication with investment products.
