A bond index fund (BIF) is a diversified portfolio of bonds that are chosen to align with the performance of a specific bond index.
Some of the most common bond indices attempt to track the US investment-grade (IG) bond market and Asiadollar credit market. Essentially, a BIF invests in those securities in the index to closely match that performance. A BIF can come in many forms, including bond mutual funds and exchange-traded funds (ETFs) that invest in bonds.
BIFs are still relatively young, with the first bond ETF launched in 2002 by iShares. ETFs simplified how investors all over the globe access fixed-income markets. Investors can use ETFs for convenient, low-cost exposure to thousands of bonds. As of March 31, 2022, bond ETFs have grown to US$1.7 trillion ($2.3 trillion) in AUM and more than 1,400 ETF products around the world.
Despite the benefits, BIFs also hold several disadvantages, such as difficulty to replicate, high tracking error and weightage problem (more indebted issuers get higher weightage).
Pros
A BIF provides investors with primarily two major advantages: diversification and low-cost investments.
Investors can gain exposure to a wide selection of bonds with different maturities, credit ratings, and issuers. This provides diversification benefits and helps to reduce the risk of investing in individual bonds. Also, most bond indices are constituted by thousands of bonds. For instance, the most commonly used US IG and Asiadollar credit market indices are constituted by 13,000 and 2,000 bonds respectively.
BIF are also generally considered to be a low-cost investment option, as they typically have lower fees than actively managed bond funds and require less frequent trading. The passive management style of a BIF comes with lower management and operating costs. Those savings can be passed on to investors in the form of lower fees.
Cons
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On the other hand, there are several key disadvantages of this asset class which investors ought to watch out for.
• Most indebted bond issuers get the highest weightage
Equity indices (eg S&P 500 & Hang Seng) are created on a meritocracy basis: the market capitalisation of their constituent companies determines the weight each company represents in the index. As a result, over time, the best-performing stocks within the index represent a bigger percentage of the index while the poor performers decrease as a portion of the index.
What many investors do not recognise though, is that, unlike passive equity indexes, passive bond indices are typically weighted by the amount of debt outstanding by the various issuers. In other words, corporations or governments that issue the most debt represent the largest proportion of the index. So essentially, a passive bond index is heavily weighted toward the most indebted issuers. Depending on the creditworthiness of those issuers, that may represent a substantial amount of additional credit risk.
For instance in Asia, China Evergrande Group — which was the second-largest property developer in China by sales and the world’s most-indebted property developer — and its subsidiary Scenery Journey accounted for 7.0% of a high-yield subindex of the leading Asiadollar index as of January 2021. The highyield subindex provides exposure to USD-denominated high-yield debt securities issued by companies in Asia. Besides, the China property sector accounted for 12% of the leading Asiadollar index as of end2020, only declining to 3.4% in December 2022 after all the defaulted issuers were excluded from the index. As a result, BIF investors may be taking substantially higher credit risk without realising it.
In the US, the leading US IG bond index, that is widely considered to be the benchmark for the US IG bond fund managers focused on the corporate bond market, may not be representative either. The index is a widely adopted benchmark that measures the IG, USD-denominated, mostly US issuers, fixedrate taxable bond market. However, based on Feb 21 data, around 72.8% of the index was contributed by AAA-rated bonds guaranteed by the US government, of which 40.8% was from government treasury, 2.5% from government-backed entities and 29.5% from US agency mortgage securitised bonds. The index is described as an IG index, yet most investors do not realise such a huge weightage on government-guaranteed bonds while corporate bonds merely accounted for 24.3% of the index.
As a result, investors may unknowingly put too much weightage on government bonds and miss out on the better risk-return dynamic of corporate bonds. Having said that, because the index owns so much US government bonds, where there is little risk of credit default, it holds up well in financial meltdowns.
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• Difficult to replicate and higher tracking error
Precise replication of the index is difficult, given the high number of bonds in the index (13,000 bonds in the leading US IG bond index as of Feb 21). Also, indices do not include trading costs, fees, or taxes among other considerations. The situation is complicated by the more expensive trading costs and weaker liquidity of bonds compared to equity.
For instance, a BIF that seeks to track the performance of the Asiadollar credit market bond index recorded a five-year total return of 4.99% while the five-year total return of the index as of Feb 21 was 6.24%, implying a tracking error of 1.25%.
The tracking error would be even larger for the Singapore dollar bond market, given the thinner liquidity of Singapore dollar bonds (compared to equity and the US dollar bond market). A bond index comprising of merely over 230 bonds from more than 90 issuers (as of Jan 31, 2020) that is designed to reflect the performance of Singapore dollar bonds recorded five-year total returns of 4.57% as at Feb 21, while a local BIF that tracks its performance recorded five-year total returns of 2.28% over the same period. This implies a tracking error of 2.28% between the bond index and BIF.
• Return uncertainty
While an individual bond has a periodic, fixed payment and an indicated maturity date at which the principal is repaid, bond funds operate perpetually and pay interest that fluctuates over time. This means that while bond buyers receive a known yield over a fixed period until maturity when they buy a bond, BIF investors do not know what total return they might receive in any given period.
Also, investors should understand that bond funds and individual bonds are fundamentally different instruments, unlike equity funds and individual stocks which share many investment characteristics. With rising rates, individual bonds held to maturity are poised to deliver a better performance than bond funds held for similar periods.
Passively investing in bonds may not be ideal
Passive investing through index replication may have a place in certain asset classes. But we think active investing is more suitable for bonds. This is in part primarily due to a bond index being (1) a passive bond index that is heavily weighted toward the most indebted issuers; (2) difficult to replicate precisely due to a high number of constituents; and (3) exposed to the relatively illiquid nature of bonds; plus (4) the relatively high trading cost of bonds.
Nevertheless, BIFs can be a useful investment option for investors who want exposure to diversification, with lower fees and the benefits of passive investing. However, like all investment options, BIFs have risks and limitations, which investors should carefully consider their options before investing.
Chin Meng Tee, Andrew Wong, Ezien Hoo and Wong Hong Wei are credit research analysts at OCBC Bank’s Global Treasury Research & Strategy
