Farewell to traditional bond benchmarks

February 6, 2012

Italian government bonds have returned as much as 11 percent this year, becoming one of the best assets in global financial markets (forget stocks, global equities have risen  just over 7 percent).

But prospective (and existing) buyers of Italy’s high-yielding debt have to face fears that they may get caught up in a wave of forced selling in the Italian paper involving as much as 140 billion euros.

This is how it works. Italy is rated a mid or low investment grade by the main ratings agencies but is vulnerable to further downgrades. An across-the-board cut to “junk” would force passive bond funds which track bond benchmarks to automatically sell the debt (For more read this).

This has been the problem of bond benchmarks ever since the credit crisis triggered by the 2008 collapse of Lehman Brothers. Because the indexes are weighted according to market capitalisation, the more indebted you are, the heavier your representation is in an index.

This is why some fund managers are either customising bond benchmarks or adopting a new framework that allows investors to invest based on a country’s liquidity, macroeconomic strength and socioeconomic stability.

At BlackRock, customised fixed income indexes are used for about 20 percent of the $60 billion managed in its passive European fixed income strategies, according to this article.

Swiss asset manager Lombard Odier Investment Managers is using a model called Fundamental Weight Driven approach.

“What’s wrong with the current benchmark is market capitalisation.  You want to invest money with people who are going to repay the debt… If Italy were to fall below investment grade, then those bonds would find it very difficult to find any buyer at any price,” says Stephane Monier, chief investment officer of fixed income and currencies at Lombard.

“Italy has a very high debt to GDP ratio and is probably growing at zero percent. If they pay 5-6 percent it will be difficult to repay the debt. Being prudent for our assets, I would like to expose ourselves less to Italian debt.”

In widely used bond benchmarks (compiled by banks such as Citi and Barclays), Italy has nearly a quarter share of the euro zone government bond index.

In the FWD approach, Italy has a weighting of less than 10 percent.

The FWD index has performed better than traditional benchmarks. Over the 10 years to September 2011, the FWD index would have risen nearly 80 percent, compared with the traditional benchmark which returned just over 49 percent, on an unhedged euro basis.

This translates into annual excess return of 1.52 percent for the fundamental approach.

“The best benchmark should have liquidity and best return for risk,” Monier says.

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