Nuances of the Barclays Fixed Income Indices

Most corporate investors use benchmarks to express their desired asset allocation, to guide their asset managers’ portfolio construction process and, on an ex-post basis, to measure their performance.

Well known indices such as the S&P 500 or the Barclays U.S. Aggregate are generally used as benchmarks. In BS (balance sheet) fixed income investing, the most popular indices are provided by Barclays Capital and by Merrill Lynch. Many of you may be using the Barclays 1-5yr. Govt./Credit or the Barclays 1-3yr. Government indices, so I thought it would be nice to present some aspects of the Barclays methodology.

(Side comment: it took me 5 or 6 years to stop saying “Lehman methodology”, as it was called from inception in the early 1970s to the bankruptcy of Lehman Brothers in 2008).

Monthly reset

• Securities are evaluated on a monthly basis to determine index eligibility. If a security meets all the criteria at the beginning of the month, it will stay in the index for return calculations until month-end.

Treatment of Cash

• Cash earned from interest and principal payments remains in the index until month-end with a 0% return.
• Real world comment: In the real world, this cash would be reinvested or swept into a money market fund and, in both cases, presumably earn a rate greater than 0%. This feature should benefit the portfolio manager (although I don’t know to what extent).

Pricing

• Main source: Barclays traders.
• Timing: 3pm New York, 4:15pm London (for European markets), different times for Asia.
• Frequency: daily.
• Side of the market: bid side, except for new corporates entering the index on the offer side (makes sense, one would have to pay the offer side to include a bond in the portfolio), and EUR & GBP Treasury bonds, which use mid (don’t ask why).
• Real world comment: the index is agnostic to transaction costs; in the real world, a portfolio manager would have to pay the offer side each time she wanted to add a bond to the portfolio and, since the index uses bid, she would be penalized.

Credit quality

• Considers the following agencies: Moody’s, S&P, and Fitch.
• Middle rating rule: discards highest and lowest ratings.
• If only two agencies rate a bond, then the most conservative rating is chosen.
• If only one agency rates a bond, then that one rating is used.
• If none of the agencies rates a bond, then the issuer level rating may be used.
• Real world comment: be cognizant of these rules when determining investment guidelines, try to be aligned with the index or be prepared to have the portfolio manager blame his negative alpha on a guideline-index mismatch. For example, a hypothetical BS portfolio manager could tell you: “your guideline for minimum credit quality uses the most conservative rating while the index uses the middle rating, therefore several index-eligible bonds are not eligible for your portfolio and, alas, those were the exact bonds that rallied… it’s the reverse of George Constanza’s it’s not you, it’s me!”

Two Index Universes: Returns and Statistics

• Each Barclays index consists of two pools of securities, or “universes”: the Returns Universe and the Statistics Universe.
• The Returns Universe is used to calculate return data, while the Statistics Universe is used to provide characteristics such as market value, sector weightings, maturity, yield, duration, etc.
• The Returns Universe contains the set of securities that meet the index eligibility criteria at the beginning of the month and does not change until the next reset date (i.e., month-end). This means that if a security is no longer eligible (e.g., due to a credit rating downgrade), it will remain in the index until month-end and, therefore, a portfolio manager will have some time to decide whether to sell the security or keep it and introduce some tracking error.
• The Statistics Universe is dynamic, it changes every day based on eligibility, so if a bond is no longer eligible, it will fall off this pool immediately.

Next up: Merrill Indices

I will provide similar details for the Merrill Lynch indices in a future entry.

If you think that any of the bullet points above is outdated or plain wrong, please send me a note or comment below. Thanks!