Bond Indexes track the performance of bonds and bond portfolios. You can easily compare your own holdings to the risk and return of other bonds within the index, or against the index as a whole. This gives you a guideline to compare your earnings for your own bonds by tracking the performance of bonds and bond portfolios. You can also compare the returns of a bond portfolio manager against a bond index to analyze their investment strategy. This gives an easy measure to determine if their performance exceeds the market.
Measuring Bond Index Performance
Bond indexes themselves come with one of two specific classifications based on their mathematical performance measurement. A Benchmark index tracks performance of a single kind of bond and bases performance relative to the bond category. Bonds either exceed or lag behind that collection of bonds.
A weighted index uses an average and proportion adjusted measurement of return. The proportion is based on the size of the original issue versus the total index. Weighted indexes give a glimpse of a specific sector of the marketplace, and the performance that can be captured by investing within it. They differ based on which bonds are included within the index itself.
This can result in shortcomings for any bond index. Index values change based on the prices of the bonds. This would be fine if all bonds had easily accessible prices, but some bonds trade infrequently or only once. Sometimes, recent pricing information is completely unavailable or outdated. As a result, index values may be estimated or assumed based on data which would otherwise be considered as expired. The bond may alternatively be dropped or not included in the index’s initial construction.
Bond Credit Rating & Bond Indexes
Bonds are also excluded from bond indexes for reasons beyond simply pricing. Firm performance or credit ratings may result in bonds being initially included within an index and eventually removed. Both performance and bond ratings can change over time. This results in bonds often being added or removed from an index.
If a bond must be excluded, investors and managers emulating the index will sell that bond. This can result in a price drop for that bond’s value, affecting investors continuing to hold the bond if they sell later. If the bond is being added to an index, managers and investors tracking the index will purchase the bond. This results in higher demand for that bond issue, and prices on the bonds will rise. Indexes have market moving implications, especially if they’re popular targets for imitation in professional or personal portfolios.
Bond Index Limitations
Quality or qualification limits result in only a specific collection of bonds being added to any index. Portfolios tracking indexes will acquire the same attributes as their target. Bond portfolios imitating the index will be expanded and limited to the index’s level of diversification. Portfolios tracking indexes with poor diversification will suffer from the same risk exposures.
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