You may recognize the Dow Jones Industrial Average (DJIA) and the S&P 500® as familiar stock market proxies cited by your portfolio manager and widely used in the financial media when describing the performance of the broad equity markets. But in the equally important world of fixed income investing, investors may be less well versed on the fundamentals of bond benchmarks. In this article, we point out some interesting features of these benchmarks and highlight how the very nature of bond benchmarks and passively managed strategies provides opportunities for our active fixed income strategy here at Segall Bryant & Hamill.
Bond Indices Exhibit Massive Scale and Differ Significantly from Equity Indices
The bond market is large…very large, in fact. In the world of government and corporate bonds, the Bloomberg Barclays Global Aggregate Bond Index (Global Agg Index) — one of the biggest bond market indices and an excellent proxy for investment grade taxable bonds — has some 25,000 constituent bond holdings (Exhibit 1). Compare that number of holdings to the 30 blue chip names in the Dow Jones Industrial Average, or the 500 stocks in the S&P 500® Index or even the roughly 3,000 stocks in MSCI’s All Cap World Index, and you get a sense of the immense scale of the publicly traded debt markets. The Global Agg Index has nearly $60 trillion in total market value — a staggering number. And since by their very nature bonds are constantly maturing or being called, which prompts steady new issuance, there is significantly higher turnover in these big fixed income indices versus their stock market peers (Exhibit 1).
Passive Fixed Income Strategies Rely on Large Bond Issues, Which Often Represent the Most Indebted Issuers
There has been a rapid rise in recent years of passive fixed income investment strategies, whereby investors seek to replicate and hold a broad bond market index, without researching individual companies in order to determine their long-term potential. The resulting dynamic has produced huge pools of capital concentrated in these types of bond funds that try to mirror the broad debt markets. This is often an impossible task given the sheer number of securities that are required to replicate a benchmark. Therefore, passive strategies often use a sampling approach (i.e., using a representative sample of securities in the benchmark), which skews them toward the larger, most liquid issues. That means they typically ignore smaller- to medium-sized issues. Importantly, small issues aren’t small companies; many are healthy issuers that simply don’t need a lot of debt. This dynamic is equally true, and often more pronounced, in the tax-exempt municipal bond world. Hence, for both taxable as well as tax-free bond markets, large swaths of quality smaller- to medium-sized debt issues fly under the radar and are often available at attractive price levels — prime hunting ground for focused, research-driven, actively managed bond strategies such as ours.
The very same tilt toward the biggest issuers in bond indices means that these benchmarks naturally skew to issuers with the most debt on their balance sheets. Whereas the biggest holdings in broad stock market averages are often the largest, most stable firms with strong prospects, the larger bond issuers with the highest debt balances may present risks to investors. These issuers are most reliant upon a well-functioning fixed income market and are therefore exposed to risks that could make repaying or refinancing that debt more difficult, whether due to broad market pressures, increases in interest rates, or deteriorating business/credit fundamentals.
Looking Beyond the Constraints of Bond Benchmarks to Active Management
At Segall Bryant & Hamill, our fundamentally driven research approach is designed to invest in areas of the bond markets easily overlooked by larger peers and to avoid issuers with the highest intrinsic risks. We are glad to share a bit of insight into the somewhat arcane world of bond benchmarks, and we welcome the opportunity to explore it further with you.
Please feel free to reach out to your portfolio manager or contact us at firstname.lastname@example.org or (800) 836-4265.
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