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What Investors Should Know About Bond Index Construction

Aug. 18, 2011 5:02 PM ETAGG, AGZ, GVI, IGSB, MUAA, MBB, GTIP
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From the iShares Blog

To index or not to index, that is the question. Or at least that’s the question many investors ask themselves when evaluating how to invest their money. Over the past decade we have seen a surge in investors answering “Index!” ETFs, most of which seek to track an index, have been a big part of this shift. 
Most people are familiar with the popular indexes in the market like the S&P 500 and the Dow. Of course, the majority of indexes people are familiar with are of the equity variety — their bond market cousins don’t have the same visibility with most investors.  Today I want to talk about what bond indexes are and how they are put together, focusing on the US and then covering international in a future post.
There are a large number of different US bond indexes out there, and they are all built a little bit differently, but the vast majority of them are rules-driven. This means that an index provider publishes a set of rules, and all of the bonds that meet those rules are included in the index. That’s it.  In this way fixed income indexes tend to be very objective, and their constituencies are fairly well understood and even predicable.  There is typically an index committee that creates the rules and provides oversight, but they have no say in the actual bonds that are selected. This is very different than some equity indexes (the S&P 500, for example), where a committee hand picks constituents based upon some objective criteria along with more subjective measures.
OK, so bond indexes are rules driven.  What are the rules?  There is a lot of variety here, but there are four big ones that apply to most:
  1. A maturity requirement: Only bonds within a specified maturity range are included.  For example, the Barclays Capital US Aggregate Bond Index includes bonds that have at least one year remaining until maturity.  Other indexes focus on specific ranges of maturities, such as the Barclays Capital US 1-3 Year Treasury Bond Index. 

  2. A size requirement: Bonds have to be of a certain size – this ensures that very small and hard to access securities are not included.  Minimum amount outstanding rules for indices can vary a bit by market, but are typically greater than $100 million outstanding.

  3. A credit rating requirement: Only bonds of a specified credit quality are included. Investment grade indices, for instance, would only include investment grade bonds, those rated BBB or better. High yield indices, meanwhile, include bonds rated BB and below. 

  4. A rebalancing frequency: Bond indexes typically rebalance monthly.  At the calendar end of each month, the index provider takes the index’s rules, applies them to all the bonds in the market and voila!  The new index constituents are determined.  Importantly, if a bond no longer meets an index’s rules, it will still remain in the index until the end of the month when the rebalancing takes place.
So what does this all mean for investors? Index rules give us a roadmap for how events in the market will impact a bond index and, as a result, an index fund that seeks to track it. If you buy an investment grade index fund, for instance, and a bond is downgraded to below investment grade, it will likely come out of index and, therefore, it will likely come out of the fund at the end of the current month.
In addition, investors should make sure they know the index’s rules before investing in a bond index fund, as those rules largely determine the types of securities the fund will be investing in. Bond index rules can be a bit arcane, but a familiarity with the basics will help you better choose between investment options. 
Bonds and bond funds will decrease in value as interest rates rise. Indexes are unmanaged and one cannot invest directly in an index.
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