Alternative beta: Equal weight corporate bond indices

KEY TAKEAWAYS

• Equal weighted corporate bond indices reduce issuer concentration compared with traditional market value weighted benchmarks in both investment-grade and high-yield markets.
• Research shows equal issuer weighting has historically delivered higher total returns in USD investment-grade and high-yield bonds, even after accounting for rebalancing transaction costs.
• Sector Neutral and Rating Neutral versions eliminate inherent overweights or underweights, while Largest Issue version improves tradeability by including one bond per ticker.

This article was written by Scott Atha, Fixed Income Indices Product Manager at Bloomberg 

Market value weighting has been the standard in fixed income indices for decades. While this will continue to be the default and natural scheme for bond indices, asset managers have been exploring other weighting schemes to differentiate their products. Equal weighting has been especially relevant and popular in equities recently due to Magnificent 7 dominance. Issuer capping is already commonly used in some areas of fixed income (i.e. high yield), and equal weighting is simply taking this concept a step further.

One of the main refutes to bond indexing is that indices are “broken” because they overweight the most indebted companies. Our research shows that this is not the case – market value weighting does not systematically overweight fundamentally weaker credits in Investment Grade corporate bonds (IG). However, our role as an index provider is to provide a menu of different options (including weighting schemes).

For investors who want to employ other weights, our modern index infrastructure supports efficient and scalable implementation.  At Bloomberg, we created the global Equal Weight Issuer indices below across investment grade and high yield as complementary offerings in the alternative beta space. Bloomberg Terminal subscribers can access this via function IN EQUAL <GO>.

Applying equal weights to all the tickers within Corporate bond indices ensures better diversification and less concentration in large issuers and sectors. On the equity side, the concentration is much more extreme – the top 10 names make up almost 40% of the large cap Bloomberg 500 index.

There is far less concentration in fixed income (top 10 issuers make up roughly 15% of the US Corporate index) given the size of the universe, and allocating the same weight to all issuers has value beyond reducing leverage.

Do equal weighted bond indices outperform market value weighted benchmarks?

Rebalancing a portfolio each month to align with equal weights will likely increase the turnover, but historically the outperformance often outweighs the transaction costs.

Indeed, to quote our research mentioned earlier: “equal issuer weighted indices can deliver improved performance in both USD investment-grade and high-yield markets, even after accounting for higher rebalancing costs”. In both USIG and USHY, the average annual total return seems to increase with the degree of the restrictiveness of the capping. Equal weighting, which is the most extreme version of concentration restriction, has the highest returns at 5.31% and 7.67% over the sample period, respectively. In particular, equal weighting issuers in HY results in roughly 100bp per year of outperformance (or 50bp net of transaction costs) since 2000 per below.

Sector Neutral, Rating Neutral and Largest Issue approaches in equal weighted bond indices

Bloomberg also provides Sector Neutral and Rating Neutral versions for investors who want to avoid inherent bets (i.e underweight large financial issuers) when applying equal weights. These versions equal weight within the underlying rating and sector sleeves, then combine together to maintain the market value of each bucket. Below is an example of sector neutrality (at Class 2 level) for the IG Corporate index.

Additionally, versions of the US IG and HY indices are available that include only the largest bond (by amount outstanding) of each ticker. So instead of dozens of bonds per issuer in some cases, these so-called Largest Issue indices maintain the same equal weights of each ticker but with only one bond (see below).

The exposure is the same, but the tradability is increased by reducing the number of constituents significantly (ie 90% fewer bonds in US IG). Not only are these versions more liquid, but they demonstrate outperformance over the long run as well (both in gross terms and net of transaction costs).

Across regions and ratings, applying the same weight to all tickers of corporate bonds usually performed better over the long run (but past results are no guarantee of future performance). As asset managers look for ways to differentiate and generate alpha, the choice of weighting scheme can lead to different outcomes. Market value weighting is the natural option for fixed income, but alternatives such as equal weighting may offer better diversification and higher returns.