Investing in fixed income: What motivates bond investors? (Part 3 of 4)
How indexation can benefit both investors and fund managers
Broad bond indexes tracked by ETFs like the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) and the Core Total US Bond Market ETF (AGG) are well diversified across sectors and maturities, and most investors can never hope to achieve this level of exposure to the bond market due to the large investment sums required, the illiquidity of many issues, and high transaction costs. For fund managers, an indexed portfolio will have relatively lower turnover and lower transaction costs relative to full-blown active management. For example, the top ten holdings in LQD include debt in companies such as Verizon (VZ), General Electric (GE), and Apple (AAPL). Although these are all large-cap companies forming part of the S&P 500 Index (VOO), they’re from totally different sectors.
Fund managers can create indices that result in different risk, return, sector, and maturity profiles. For example, the Market Vectors Investment Grade Floating Rate ETF (FLTR) ETF tracks Market Vectors Investment Grade Floating Rate Bond Index, which is composed of U.S. dollar–denominated floating rate notes issued by corporate issuers and which are rated as investment-grade (rated BBB- and above by at least one major rating agency).
Investors must always compare the fund manager’s portfolio performance to a benchmark whose characteristics match those of the portfolio. Key factors to consider while selecting a benchmark are:
- Interest rate risk
- Income risk
- Credit risk
- Liability framework risk
To read about one of the most important concepts in bond markets, continue to Part 4 of this series.
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