Effective bond indexing—that is, constructing a bond portfolio that matches a benchmark index—need not fully replicate the bond index. Instead, you can achieve this balance by matching the primary risk factors of the managed index to the benchmark.
For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), seeks to match the price and yield performance, before fees and expenses, of the iBoxx $ Liquid Investment Grade Index, which is composed of the U.S. dollar–denominated liquid investment-grade corporate bond market. The SPDR Barclays Capital High Yield Bond ETF (JNK) tracks the performance of the Barclays Capital High Yield Very Liquid Index. In the preceding parts of this series, we’ve discussed ways to match some primary risk factors. In this article, we’ll look at other risk factors that the portfolio manager must match.
Present value distribution of cash flows
A portfolio’s exposure to yield curve twists—non-parallel movements in the yields curve—can also be approximated by using the present value distribution of cash flows as a proxy for estimating an index’s yield curve risk and seeking to match that distribution. By matching the percentage of the present value of cash flows (both coupons and redemptions) at certain time intervals with that of the benchmark index, the fund manager can prevent the tracking error associated with yield curve twists.
How to match the present value distribution of cash flows
To match the present value (or PV) of cash flows from the benchmark index, you must determine the cash flows that fall in every one-year period. Then you must divide the present value of cash flows in each period by the PV of total cash flows from the benchmark to determine the percentage of the index’s total market value attributable to cash flows falling in each period. These are the weights of each period.
Since the cash flows can all be considered zero-coupon bonds, their duration is the end of the period. The first year has a duration of one, the next is two, and the next is three, et cetera. Then the manager multiples the duration of each period by its weight to arrive at the duration contribution for that period, which is divided by the index duration (the sum of all the periods’ duration contributions, which will give the PV duration contribution of the cash flow from each period. This will give the index present value of duration, or PVD. If the manager duplicates the index PVD, the portfolio will have the same sensitivities to both shifts and twists in the yield curve.
In the next part of this series, we’ll look at some other primary bond index matching factors. Please read on.