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Price Perspective - In Depth

Fixed Income

A Unique Approach to Bond Indexing

Robert M. Larkins, CFA, Portfolio Manager, U.S. Bond Enhanced Index Fund

Executive Summary

  • By design, passive fixed income strategies routinely fall short of benchmark performance after deducting management fees, while accepting tracking error as an inevitable part of the indexing process.
  • Recognizing that there will always be some amount of inherent tracking error, the T. Rowe Price US Aggregate Bond Index Strategy explicitly targets a low, “index like” level of tracking error. We aim to convert it into a modest amount of positive excess return, with the goal of matching or slightly exceeding benchmark returns after expenses.
  • To achieve this objective, we capitalize on the structural inefficiencies of the Bloomberg Barclays U.S. Aggregate Bond Index. We focus on less volatile sources of return within the benchmark to optimize yield, while replicating key index risk factors to minimize tracking error.
  • A secondary aspect of our approach is to take advantage of T. Rowe Price’s credit research capabilities to seek to generate incremental alpha and manage risk. 
  • Our bond index strategy has a track record of generating minimal tracking error and consistent net-of-fee index performance. The average passive strategy, in contrast, experienced performance volatility versus the index but provided no compensating excess return.

As the debate about the pros and cons of active versus passive management rages on, investment vehicles that track market indexes have continued to garner robust cash flows, steadily gaining market share from their active counterparts. Once largely an equity phenomenon, passive investing has more recently gained momentum in fixed income. A large portion of these passive fixed income flows have poured into strategies that attempt to mirror the Bloomberg Barclays U.S. Aggregate Bond Index as investors seek low-cost, high-quality bond portfolios to generate income and hedge equity risk. In an effort to consistently deliver benchmark returns after expenses, T. Rowe Price has developed a unique approach to bond indexing that capitalizes on the bond market’s structural inefficiencies to optimize returns while carefully matching key index risk factors. 

TRACKING ERROR UNAVOIDABLE WITH BOND INDEXING

Notwithstanding the proliferation of passively managed fixed income assets, “pure passive”—or full index replication—is not viable using conventional bond benchmarks. While it is possible to fully replicate equity benchmarks such as the S&P 500 Index, which focuses on the largest, most liquid U.S. stocks, bond indexes are a more complex animal. The widely followed Bloomberg Barclays U.S. Aggregate Bond Index, for example, includes more than 9,500 individual bonds from disparate sectors with varying degrees of liquidity and efficiency.

Bond benchmarks experience significantly higher turnover than common equity indexes. New issuance, maturities, early redemptions, and credit rating changes are among the factors that cause the composition of bond indexes to continually change. This is problematic in largely over-the-counter bond markets, where specific bond issues are often not available in the desired size, and trading costs can be punitive to performance.

Due to these sorts of challenges, bond index strategies use various sampling techniques to approximate index sector weightings and risk characteristics. Sampling bias, along with transaction costs and cash flow disparities, leads to inherent tracking error—or volatility in portfolio returns relative to benchmark returns. Tracking error is essentially a measure of how closely portfolio performance follows the index and is an inevitable part of any indexing strategy. 

A BETTER APPROACH TO INDEXING

Like its passive peers, the T. Rowe Price US Aggregate Bond Index Strategy also strives to track the index closely. But rather than simply seeking to minimize tracking error, we target a
low “index like” tracking error that is in line with passive peers. To guide portfolio construction, we employ a multifactor risk model to forecast tracking error and isolate the sources of risk. As shown in Figure 1, the strategy’s tracking error has been consistent with its passive institutional peers over time.1

The key difference between our approach to bond indexing and that of the typical passive strategy is how we think about tracking error. By design, passive strategies routinely fall short of benchmark performance after deducting management fees, while accepting tracking error as part of the process. We believe there is a better approach: Rather than simply accepting tracking error as an inevitable part of indexing, we aim to convert it into a modest amount of positive excess return in order to match or slightly exceed benchmark returns after expenses.

As depicted in Figure 2, the strategy has consistently generated a positive information ratio, which measures a portfolio’s excess returns versus the benchmark per unit of tracking error. This indicates that we have generated low tracking error volatility and successfully transformed much of it into a modest amount of alpha. The average passive strategy, in contrast, generated volatility versus the index but provided no compensating excess return. 

FIGURE 1: Tracking Error Comparison
Q4 2011–Q4 2017 

Sources: eVestment and T. Rowe Price.
Annualized (rolling 60-month periods calculated quarterly). Tracking error calculation for the T. Rowe Price US Aggregate Bond Index Representative Portfolio based on 3 p.m. ET pricing versus the benchmark.
Past performance cannot guarantee future results. Quarterly statistics are based on gross returns.
Returns would have been lower as the result of the deduction of applicable fees.
*The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. Information regarding the representative portfolio and, where applicable, the other accounts in the composite is available upon request. Please see the GIPS® Disclosure page for additional information on the composite. Supplemental information. 

FIGURE 2: Information Ratio Comparison
Q4 2011–Q4 2017

Sources: eVestment and T. Rowe Price.
Annualized (rolling 60-month periods calculated quarterly). Information ratio calculation for the T. Rowe Price US Aggregate Bond Index Representative Portfolio based on 3 p.m. ET pricing versus the benchmark.
Past performance cannot guarantee future results. Quarterly statistics are based on gross returns.
Returns would have been lower as the result of the deduction of applicable fees.

* The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. Information regarding the representative portfolio and, where applicable, the other accounts in the composite is available upon request. Please see the GIPS® Disclosure page for additional information on the composite. Supplemental information. 

APPEARANCES CAN BE DECEIVING IN FIXED INCOME

When trying to approximate bond index characteristics, another challenge for index trackers is that sector weightings alone provide limited insight into risk. A portfolio can maintain sector weightings that are identical to the benchmark but possess a very different risk profile given the many nuances of fixed income investments. Therefore, it is more instructive to look below the surface to more deeply analyze underlying risk factors. In a core U.S. bond portfolio, the primary risks include spread, duration, and curve exposures.

Spread risk within the Bloomberg Barclays U.S. Aggregate Bond Index derives from fluctuations in credit spreads as investors’ perceptions of credit quality change. Using nominal sector weight percentages to assess spread risk can be highly misleading. As a case in point, investment-grade corporate bonds constitute about a quarter of the benchmark in terms of nominal sector weight. However, because corporate spreads can be more volatile than spreads of other high-grade sectors, corporates actually dominate the index when analyzing each sector’s contribution to total spread volatility (Figure 3). It is therefore critical to think in terms of risk metrics rather than simple weight percentages. 

FIGURE 3: Nominal Index Sector Weights Provide Limited Insight Into Credit Risk

Source: Barclays POINT.
*Calculated as each spread sector’s percentage contribution to total benchmark spread volatility. Treasuries are excluded from the chart on the right because they are assumed to be free of credit risk. Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright ©2018. Bloomberg Index Services Ltd. Used with permission. 

MORE EFFICIENTLY REPLICATING THE BENCHMARK

To achieve our objective of modestly outperforming the benchmark after expenses, we aim to exploit the benchmark’s structural inefficiencies to enhance yield while simultaneously replicating index risk factors to minimize tracking error. Our primary method is utilizing quantitative analysis to emphasize areas of the market that offer lower volatility of excess returns, while deemphasizing areas where excess returns are more volatile.

For example, as shown in Figure 3, corporate credit risk is responsible for much of the index’s spread volatility. Our corporate credit team’s research has found that short- and intermediateterm corporate bonds have historically generated stronger risk-adjusted returns than longer-dated corporates. Although shorter-term corporates typically offer lower yields, they have historically provided more spread per unit of duration risk. Moreover, more of that spread can be successfully “captured”—or converted into excess returns (Figure 4). As time to maturity increases, so do risks that can reduce the spread that investors effectively capture (e.g., ratings downgrades, defaults, and early redemptions).

FIGURE 4: Greater Spread Pickup per Unit of Duration Risk in Shorter-Term Corporates
Bloomberg Barclays U.S. Aggregate Bond Index, as of December 31, 2017

Source: Barclays POINT.
Note: The option-adjusted spread (OAS) capture ratio equals excess returns divided by OAS between August 30, 1996, and December 31, 2017. The chart excludes the 30+ year maturity bucket as it represents a minimal portion of the index.
Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright ©2018. Bloomberg Index Services Ltd. Used with permission. 

MANAGING THE UNDERLYING COMPONENTS OF RISK WITHIN SECTORS

We take advantage of these inefficiencies by building the portfolio’s corporate risk factor using the more efficient parts of the corporate universe. This means underweighting the long end of the corporate credit curve in favor of the more efficient short and intermediate sections.
To match the index’s corporate spread risk factor, we need to buy more short- and intermediate-term corporate bonds to compensate for the amount that we are underweight at the long end. We offset these differences by buying fewer intermediate-term Treasuries and more long-term Treasuries to keep overall duration and yield curve exposures consistent with the index.

Optically this makes the portfolio appear overweight corporates and underweight Treasuries on a simple percentage-weighting basis. However, the reality is that the risk profile is nearly identical. This carefully designed structure matches the index’s risk factors but does so with slightly higher yield (Figure 5).

Similarly, our optimization model has shown that short-dated asset-backed and commercial mortgage-backed securities (ABS and CMBS, respectively) are an attractive source of less volatile excess returns. Slightly overweighting these high-quality securitized credit sectors, which possess very small weightings in the index, can boost yield while only slightly increasing tracking error. Again, this highlights how we utilize our low defined tracking error more efficiently to add value. 

FIGURE 5: Matching Key Index Risk Factors in a More Yield-Advantageous Manner
As of December 31, 2017 

Source: T. Rowe Price.
Source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright ©2018. Bloomberg Index Services Ltd. Used with permission.
Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current
levels, bond portfolio total returns will decline and may even turn negative in the short term.
* The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. Information regarding the representative portfolio and, where applicable, the other accounts in the composite is available upon request. Please see the GIPS® Disclosure page for additional information on the composite. Supplemental information.

OPTIMIZING DURATION AND CURVE EXPOSURES

Duration is the main driver of total return and risk in a high-quality bond portfolio. A modest duration mismatch can significantly impact relative performance, particularly when rates move sharply. However, managing the portfolio with a bias to being structurally slightly longer in terms of duration posture can add a small amount of additional carry and also act as a positive carry hedge to the slightly increased credit exposure.

Different areas of the yield curve can also be more efficient than others. We have generally favored a “bulleted” posture that places slightly more emphasis on the intermediate section of the curve. This area of the curve provides more attractive yields than the front end with less volatility than the long end. Moreover, steepness in the intermediate section of the curve can provide positive “roll down” return. Assuming that interest rates hold steady, bond prices usually rise as time passes when the curve is upward sloping. The long end of the curve is currently much flatter, providing less potential to earn roll-down return.

It is important to note that duration and curve deviations can add tracking error very quickly. We therefore keep any differences small and monitor duration and curve exposures closely. 

Price Perspective - In Depth

Fixed Income - A Unique Approach to Bond Indexing

Fixed Income - A Unique Approach to Bond Indexing
Author: Robert Larkins
Date: March 2018

 

APPENDIX A: PEER GROUP CONSTRUCTION METHODOLOGY

T. Rowe Price US Aggregate Bond Index Strategy with similar institutional passive index strategies, we constructed a custom peer group average using data from the eVestment database as of December 31, 2017. We looked at strategies in eVestment’s U.S. passive core fixed income universe that are benchmarked to the Bloomberg Barclays U.S. Aggregate Bond Index (or its floatadjusted equivalent). We then calculated a simple average and an asset-weighted average for annualized returns, tracking error, and information ratio statistics using available eVestment data.

For the asset-weighted average performance figures, we factored in the size of each strategy’s total assets under management as a percentage of the total assets of the peer group to reflect the fact that a few bond index strategies have an outsized market share and, therefore, have a large impact on the overall category’s performance and risk characteristics. Using eVestment data, we calculated a weighting factor for each strategy based on its total assets under management reported as of December 31, 2017. We then multiplied each strategy’s weighting factor by its respective performance statistics for each period. The sum of these numbers provided the asset-weighted results for the overall peer group. 


1Please see Appendix A for passive peer group construction methodology.

Key Risks—The following risks are materially relevant to the strategy highlighted in this material: Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment. Investments in High Yield involve a higher element of risk.


Important Information
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc. All rights reserved.

201803-447818

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T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

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A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

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