What is described above is only applicable to equity index building. For Bond index creation, the eligibility standards, using Bloomberg Barclay’s methodology guide for illustration, mainly are
- Currency Denomination,
- Sector Classification,
- Credit Quality,
- Amount Outstanding,
- Time to Maturity,
- Country of Risk,
- Market of issue/placement type,
- Subordination of a security etc.
The details are as below. (Referencing the Bloomberg Barclay Indices Methodology Guide)
- Currency Denomination
Currency Denomination of a bond’s principal and interest payments, for U.S. bond ETFs, has predominantly been mandated to be U.S. dollars.
- Sector classification
Sector Classification of the bond issuer, recognizes the wide range of issuer types in the fixed income market including corporate, municipal, county government and securitized borrowers.
- Credit quality
Credit Quality of a bond is measured by the rating agencies, which mainly are Moody’s, Standard and Poor’s, and Fitch. This is important for index users with investment guidelines that make a clear distinction between investment grade (rated, e.g., Baa and higher) and high yield (rated e.g. Ba and lower) securities.
- Amount outstanding
The amount outstanding of a bond, with larger bonds, generally more widely held by investors and viewed as liquid.
- Time to maturity
Time to maturity of a bond’s principal repayment should be taken into consideration.
- Country of risk
Country of risk of the issuing entity, especially in cases where an investor may make a distinction between developed and emerging markets in their portfolios.
- Market of issue/placement type
Market of issue/placement type of a security reflecting whether a bond is (or will soon be) publicly registered, exempt from registration or privately placed. This also indicates whether a bond is being marketed and sold to local investors only, non-local investors or globally offered in multiple markets.
Tax implications of a security’s cash flows and principal payments from an issuer’s and an investor’s perspective. From the issuer perspective, distinctions are made when a borrower on a pre-tax basis (debt) vs. after-tax basis (equity dividend) makes cash payments. From the investor perspective, a different investor base than taxable bonds generally buys bonds that offer tax-exempt proceeds (particularly US municipal securities).
- Subordination of a security
Subordination of a security identifies where an investor’s claim is within the borrower’s capital structure, distinguishing between bonds that have senior claims and those that have subordinated claims in a credit event. Other attributes that are used to determine index inclusion include whether a bond contains explicit optionality on the earlier repayment of principal (callable, puttable, etc.) and the coupon type used to determine interest payments (fixed- vs. floating-rate).
As fixed income markets continue to evolve, new types of bond features and structures are brought to market. When evaluating new security types for the purposes of index eligibility, a number of factors are taken into account, including, but not limited to, existing index rules, eligibility precedents of similar types of debt and the views of clients and internal research.
The fixed income asset class presents layers of complexity far greater than those in commonly used equity classification schemes because of the diversity of issuer and security types. In addition to corporate issuers and central government borrowers, a broad universe of government-related entities (supranational, local governments, government agencies) and securitized structures with bankruptcy remote issuers or ring-fenced assets must be classified appropriately.
It’s worth noting that the Bloomberg Barclays Global Sector Classification Scheme (BCLASS) is a widely accepted standard for investors benchmarked to the flagship Bloomberg Barclays aggregate bond indexes or a sector-based sub-component of these indexes. It is designed to reflect the large universe of corporate, government, government-related and securitized bonds that comprise the global fixed income investment choice set. In addition to corporate bonds, this universe also includes central government sovereign/treasury bonds, government-related or quasi-sovereign bonds, and securitized bonds backed by a pool of assets rather than the unsecured credit of an issuer.
On a high level, Index-eligible bonds are divided into four categories: treasury, government-related, corporate and securitized.
Representative types of these ETFs and their underlying indexes will be discussed in the later part.