As the Greece situation continues to develop, I’ve been hearing a lot of client questions about the exposure to Greek debt in some of our iShares fixed income ETFs. With good reason, too – investors are wondering whether downgraded Greek bonds will be removed from the funds in which they currently reside. It’s a fair question, and it really highlights some of the points I made in my last post on index construction. Of course, last time I focused on US indexes (which are fairly straightforward). The Greece example gives me a good excuse to cover index rules for non-US bond indexes.
In many ways, international bond indexes are similar to their US counterparts. The four big index rules that we discussed before still largely apply. But international indexes also have an additional wrinkle: varying rules on classifying countries as developed or emerging markets. In other words, one index provider’s emerging country is another’s established player.
Luckily, there are three common methods that most fixed income index providers use to determine whether a country is emerging or developed. Some providers classify countries using the World Bank’s reporting of average income level in a country. For example, JP Morgan’s Emerging Market Bond Indexes define an emerging market as a low- or middle-income country, using the World Bank’s data to ascertain which countries fall into that category. Other providers use the Bank of International Settlements’ (BIS) country classifications. And finally, an index provider might use a committee to determine if a country is developed or emerging based on a range of criteria such as liquidity, income standards, ratings and other factors. This last method is used by the Barclays Capital Index family.
Of course, most definitions of “emerging vs. developed” are based on the idea that emerging market countries move to developed market status through time. However, this may not always be the case – and Greece is a possible example. While Greece is generally still thought of as being part of the developed world, Greek debt was downgraded by Standard & Poor’s in July 2011 to CCC, a firmly speculative rating. Unfortunately, there isn’t a consistent view among index providers of how this downgrade will impact Greece’s classification as a country. Instead, the treatment of Greece varies by provider and by index methodology. Here’s a look at how the Greece situation is currently being handled by various types of international fixed income indexes:
- Investment grade global indexes – Since Greek debt is no longer considered investment grade, it was removed from investment grade global indexes (such as the Barclays Capital International Treasury Bond Index) at the end of June 2010.
- Developed market indexes – Since Greece is still considered developed by the World Bank and BIS, Greek debt is still included in developed market bond indexes (such as the S&P/Citigroup International Treasury Bond Index).
- Indexes that cover both developed and emerging markets — Greece is still in these indexes (such as the BofA Merrill Lynch Global Diversified Inflation-Linked Index), and likely won’t be dropped by them unless the country actually defaults by missing a coupon or maturity payment.
While the jury is still out on the ultimate classification of Greece, it’s clear that the rules around country classification are themselves a bit undeveloped. Familiarization with them can help bond index fund investors better know what they own.