Fixed income investors
We can understand the investment objectives of fixed income investors in terms of returns, risks, and constraints. There are two categories of investors:
- Investors who define objectives in terms of a fixed cash flow that they expect the portfolio to generate to meet a pre-determined liability structure
- Investors who specify a benchmark bond index and the fund manager’s objective in terms of either matching index performance after management fees or outperforming the index by a pre-determined number of basis points (or bps, with each basis point representing 0.01%)
Investors must communicate their objectives to fund managers and evaluate fund performance in terms of these objective—whether they relate to liability or performance versus a specified benchmark.
Fund managers who seek to match liabilities as their investment objective
There are two types of investors seeking to match a pre-determined liability schedule.
- Funded investors are investors who invest borrowed proceeds and expect to earn a higher return on these funds than their borrowing cost. The difference between the expected return on the bond portfolio and the cost of borrowing is called the “spread.” Examples of funded investors include depository institutions like banks, credit unions, and insurance companies issuing guaranteed insurance contracts.
- There are also investors who must meet a liability structure but who haven’t borrowed funds to generate returns to meet their liability structure. Examples include pension sponsors seeking to match defined pension benefits.
Fund managers whose performance is evaluated against a specified bond index benchmark
The investors may or may not have a liability structure, but the fund manager’s performance is benchmarked irrespective of the performance of a designated bond index. Popular ETFs whose returns are benchmarked against a pre-specified index include the following.
- The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) tracks the iBoxx $ Liquid High Yield Index. The index is rules-based and provides a broad representation of the U.S. dollar–denominated liquid high-yield corporate bond market. With an expense ratio of 0.5%, the top ten holdings in HYG include Sprint 144A 7.875% (S), with 0.55% of total assets.
- The SPDR Barclays Capital High Yield Bond ETF (JNK) tracks the Barclays Capital High Yield Very Liquid Index. The index includes publicly issued, non–investment-grade, fixed-rate, taxable corporate bonds with a maturity in excess of one year and rated high yield (at or below Ba1 by Moody’s or BB+ by S&P and Fitch), with $600 million or more of outstanding face value. The top holdings in JNK include First Data 12.625% (FDC), with 0.73% of assets, and Sprint 144A 7.875% (S), with 0.63% of assets. JNK has an expense ratio of 0.4%.
- Issued by Van Eck, the VanEck Vectors Investment Grade Floating Rate ETF (FLTR) ETF tracks the VanEck Vectors Investment Grade Floating Rate Bond Index, which comprises U.S. dollar–denominated floating rate notes issued by corporate issuers and rated investment-grade by at least one of three rating services. The top holdings in FLTR include JP Morgan Chase FRN (JPM). JPM is a multinational financial institution that forms part of the S&P 100 (OEF) Index, which includes the largest 100 companies in the U.S. by market capitalization.
- The iShares 10-20 Year Treasury Bond ETF (TLH) tracks The Barclays Capital U.S. 10–20 Year Treasury Bond Index, which measures the performance of U.S. Treasury securities that have a remaining maturity of at least ten years and less than 20 years.
To learn more about the risks associated with various bond investment strategies, read on to Part 2 of this series.