Morningstar - Fall 2019 - 31

"What would it look like if the synergies in M&A
did not pan out or sector fundamentals
deteriorated?"
Government she said. "Our estimate is there
could
be maybe $60 billion to $120 billion
Agency
19.0%
worth
MBSof fallen angels. That's something the
high-yield
market over time could accommodate."
Corporate
(Fellow panelist Laird Landmann wasn't
so sanguine.)
42.5%
Meanwhile, investor capital has increasingly
flowed to passively managed fixed-income
strategies over the past 10 years. Investing in
bonds via index trackers lags passive share on the
equity side, but it is gaining traction. The
exchange-traded fund revolution has included
fixed income, with bond ETFs surpassing a milestone,
$1 trillion in assets under management, in early
2019. When we add in index-tracking fixedincome mutual funds, the passively managed
figure is closer to $2 trillion.

Despite their rising popularity, passive fixedincome strategies are far trickier to implement
than equity index trackers. In a study on
the performance of bond funds, Morningstar
27.8% Matias
researchers
31.0% Mara Dobrescu,
42.1%
Möttölä, and James Li blame the complexity
of bond benchmarks for the struggles of
many 7.5%
managed fixed-income strategies to
28.8%
outperform. They write: "In markets
1.3%
where transaction costs are particularly
elevated,
both active funds and ETFs have struggled
to match the performance of the index."1
The transaction costs they reference include
illiquid and hard-to-trade securities, as
well as frequent rebalancing.

Why? Companies have taken advantage of low
interest rates to issue lots of debt, but with
multiple bonds from the same issuer on the market,
investors have preferred the latest issues.
Turnover on bonds declines rapidly within months
of issuance. The secondary market has dried
up. This has led to rising transaction costs
for trading in the cash market and protracted
times for executing trades.

Liquidity Concerns
Transaction costs are as much of an Total
issueNet Assets
as ever, thanks to a confluence of
$2,000B
factors that bond index providers,1,727
including
1,505Global
Morningstar, must address.
1,267
regulatory
From less than 15% market share in the fund and
1,084 reform has affected broker/dealer 1,000
952 balance sheets, leading to higher capital
ETF space in 2008, passively managed 785
745
645 of overall
strategies as527
a percentage
fixed-income
costs on trading desks and lower bond
443
0
inventories. The result has been a significant
fund assets approached 30% in the United
03/2010
03/2011
03/2012
03/2013
03/2014
03/2015
03/2016
03/2017
03/2018
03/2019
States, 20% in Europe, and 15% in Asia at the end
erosion of market liquidity. While

of 2018 ( E X H IB IT 2 ). This compared to passive
share of roughly 45% of equity fund and ETF assets
in the United States and 35% in Europe.

the amount of corporate bond issuance
has exploded in recent years, trading
volume has fallen.

EXHIBIT 2

Doubling Down Market shares of passive fixed-income funds have doubled over the
past decade in Asia, Europe, and the U.S.
Asia

Europe

United States

Total Net Assets
30%

0
2008

2009

Source: Morningstar.

2010

2011

2012

2013

2014

2015

2016

2017

2018

One way for index providers to address the
challenges of changing market dynamics
is to build indexes using the most recently issued
"on the run" securities, which tend to be the
most actively traded and liquid. These bonds can
then proxy a larger number of similar securities
from the same issuer. The weightings of
each issuer, based on market capitalization, can
continue to reflect the full complement of
securities outstanding. The resulting indexes
should have fewer securities and superior
liquidity relative to peers. But their tracking error
versus those peers should usually be low.
A Complicated History
Bond indexing has long been a challenge for
investors. Whereas data and publishing firms have
always dominated the world of equity indexing,
bond indexes were historically the province
of investment banks. The banks' near monopoly
on bond trading data gave them a handy tool
with which to control bond indexes. The banks also
enjoyed the benefits of relationships with
investment-banking clients issuing securities who
expected research coverage, not to mention
inclusion in indexes used by the banks' customers
buying those instruments on the other side of
the house.

Index construction under this paradigm was never
really geared to serve end investors. Over
the years, indexes became sprawling, evolving
into complex collections of eclectic sets of
benchmarks. Many employed a tremendous level
of fine slicing and duplication, as well as sector
combinations meant to approximate strategies for
very specific investment styles.

1 Dobrescu, M., Möttölä, M., & Li, J. 2018. "Finding Bond Funds That Can Beat Their Benchmarks After Fees." Morningstar White Paper, May. See also "Priced to Fail: Fees Eat Away at Bond
Funds' Excess Returns," Morningstar magazine, August/September 2018, PP. 31-37.

global.morningstar.com/Morningstarmagazine

http://global.morningstar.com/Morningstarmagazine

Morningstar - Fall 2019

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