How fixed income index providers’ business models are evolving

With less transactional data, pricing evaluators must remain as close to the market as possible and provide indicative values from a variety of other sources to provide accurate indicative prices on index bonds. Even when there are observable inputs in less liquid markets, those too must be properly screened and evaluated with additional scrutiny to ensure they properly reflect the fair market value of index securities and not off-market or distressed transactions.

JoI Europe: Do different index clients have different needs and if so how is this expressed (e.g. traditional ETFs vs. swap based ETFs vs. institutional bond funds)?
Dancygier: The size and management style of the underlying portfolio will influence the choice of index. Funds that are looking at replication, or with a very low tolerance for tracking error such as swap-based funds, require more narrowly defined indices with stringent liquidity filters, whereas other funds can deal with liquidity issues through sampling and other replication techniques, so they can look at broader-based indices.

Upbin: Of course different index clients have different needs. This is often expressed in the differences between the standard and bespoke benchmarks that are used by different investors. I would almost go as far as to say that every index client has different needs, but they may just be able to meet those needs with a standardised offering.

As an example of different index preferences, take investors that use very broad indices as portfolio performance targets, compared with those that use narrower or more tradeable indices to track a more liquid subset. Some investors are skilled at replicating broad market indices very closely while others prefer more tradeable indices for replication purposes.

Another example of unique needs is given by ETF providers, who require different diversification rules to those used by traditional fund managers in order to list an exchange-traded product. We have also seen examples of investors requiring net-of-tax indices, which adjust standard index returns or their specific tax obligationsin different markets. A final example is liability driven investors, who will have different requirements for their preferred benchmarks that are unique to their specific future obligations.

There are a lot of variables and index design options available to fixed income users and new ones come up every day as the need arises.

JoI Europe: How do you reflect transaction costs in the underlying securities when calculating indices?
Dancygier: Transaction costs are a very important consideration when designing fixed income indices and the Markit iBoxx indices contain many features which seek to limit unnecessary turnover (which would result in transaction costs), such as minimum time-to-maturity thresholds and minimum run periods.

The Markit iBoxx benchmark indices are evaluated daily using consolidated bid prices and new inclusions enter the index at ask (offer) prices. This allows for a closer reflection of actual trading costs. For our liquid indices, where there is a greater emphasis on tradeability, the size of the investment into new index entrants depends directly on the proceeds of the sale of index removals. Further customisation allows for greater consideration of transaction costs: for example, by assuming a fixed cost per rebalancing, less frequent rebalancings or more commonly by calculating the actual index transaction cost based on bid-ask market prices.

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