EDHEC-Risk Institute research on corporate bond indices finds index construction methodologies unreliable

Written on 03 November 2011.

The research, entitled A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures, shows that credit and interest rate risk exposures are 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 paper analyses two sets of four corporate investment-grade bond indices each, one for the US market and the other for the euro-denominated bond market. The authors, Felix Goltz, Head of Applied Research, and Carlos Heitor Campani, Research Assistant, EDHEC-Risk Institute, review the uses of bond indices and the challenges involved, and then analyse the risk-return properties and the heterogeneity of the indices in each set.

Among the findings of the study:

- An analysis of the stability of the indices' risk exposures (interest rate and credit risks) reveals very unstable measures over time and, perhaps most importantly, this instability is accentuated in the two indices with the smallest number of bonds: the more investable the index is meant to be, the less reliable it is.

- Great differences are found between US and euro-denominated indices: US corporate bond indices showed higher credit risk, with longer terms to maturity and hence longer durations. Therefore, choosing a bond index in US or in Europe seems to be more than just choosing a currency exposure.

- The authors conclude 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.

- Faced with the shortcomings of traditional indices, new forms of bond indices have been proposed, but they fail to address the most pressing problem with existing indices: the stability of the duration.

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