Pricing a bond index is a vexed process

Passive investment in both bonds and equities is on the rise. But a process that seems like simplicity itself in the world of stock markets has hidden complexities when it comes to fixed income.

Of more than $2.8tn invested in exchange traded funds, vehicles that follow the movements of an underlying index, almost a fifth is in fixed income, according to ETFGI, the London-based consultancy.

But bonds and other fixed income instruments are very different from listed equities, where ETFs started out, and the indices the ETFs track are less straightforward. In particular, pricing the components of a bond index is a vexed process.

"One of the problems is that not all bonds in the index might trade every day," says Kate Hollis, a senior consultant at Towers Watson, the consultancy. "Or the bond may have traded but at a quite different size than you are contemplating."

A transaction for $1,000 is unlikely to affect the price, but a transaction for $1m could move it significantly, she explains.

In the US, all trades in investment-grade, high-yield and convertible debt must be reported on Trace, a platform created by the Securities and Exchange Commission, the regulator. Fewer than half of all reportable bonds were traded in the month of March, according to figures from Interactive Data, a market information provider.

Establishing a fair price for the other half would be challenging. In Europe, the situation is even more difficult, because there is no obligation to report the trades and no transparent mechanism for collating and publishing trade data.

"There are three routes you can go down for getting prices for a bond index," says Astrid Ludwig, head of bond and complex indexing at Solactive, a recently established index provider based in Frankfurt. "You can use quoted prices, which is some trader just sending a quote to the market. The problem is this is one person who can have a large influence on the index."

The second option, using traded prices, has similar problems, says Ms Ludwig. A single trade in an illiquid instrument is not necessarily representative of a market valuation, so again it means a single trader has disproportionate influence on an index.

It is also possible to use a panel of market participants to establish an average traded price. However, since it was discovered that interest rates such as Libor, which used this method, were regularly fixed to the advantage of those submitting the prices, this method has fallen out of favour.

"Solactive uses evaluated prices," says Ms Ludwig. This means it pays a data provider such as Interactive Data for its services. Evaluating prices involves gathering different kinds of market information, from individual transaction terms to the yield curve for companies, sectors and geographies, volumes of trade and time to maturity, to construct an imputed market price for any bond, regardless of whether it has traded recently or not.

Another market information provider, Markit, runs its own indices, in particular the iBoxx fixed income family. It used to use a panel system to establish prices and, in 2010, commentators praised this as more robust than single-source pricing. Since then, however, Libor and other benchmark-fixing scandals have drawn regulatory attention to the conflicts that arise in such systems.

Markit has updated its data gathering to include "enriched data sources to be as representative of the underlying single issue market as possible", says Sophia Dancygier, managing director for indices at Markit. This means they are using Markit's evaluated-prices services as well as other market data.

This move stood Markit in good stead when the International Organisation of Securities Commissions published Principles for Financial Benchmarks in 2013. Although the principles call for transaction-based data to be used where possible, Iosco acknowledges this is not always possible and has consulted with the industry to establish best practice.

The European Securities and Markets Authority has also taken an interest, promulgating its own set of principles in advance of a regulatory framework under construction in Brussels.

During the consultation process, industry respondents pointed out that increasing the compliance requirements (and therefore cost) for those submitting price data to index providers might discourage some companies from contributing. The regulator's response was to suggest that index providers should "develop policies to discourage withdrawals from panels and surveys".

The regulatory pressure on index providers pales into comparison with that on investment banks, another factor that has driven change in the bond index sector. Traditionally, bond indices have been provided by investment banks using data from their own trading desks. They were effectively given away for free (or for nominal fees) in order to encourage deal flow through trading desks.

This situation is no longer tenable, as the conflicts of interest are perceived to be too high. "Banks' compliance departments are clamping down on their trading desks sharing prices," says Christos Costandinides, an independent ETF consultant who used to work for Markit, and before that db x-trackers, Deutsche Bank's ETF arm.

"This does not help with making data on prices."

While it is becoming harder to source panel data for independent indices, single-source indices produced by the banks themselves are also falling out of fashion, as banks get out of the business.

"We see business coming from there [that used to go to the investment banks]," says Ms Ludwig at Solactive, "so it is good for us".

ETF providers are aware of the challenges of pricing bonds, which is why there is an emphatic distinction between benchmark indices, which may include a basket of up to 3,000 constituents, and liquid or tradeable indices, which will include anything from 30-40 to 500-600 individual instruments.

It has taken a while to reach the position where there are freely tradeable indices, says Ms Hollis at Towers Watson. "People like to say fixed income smart beta (a term for bespoke indices intended to capture particular aspects of market moves) is where equity was five years ago," she comments. "But actually a lot of the work we have done is just making indices better."

This might involve ensuring only the more liquid issues are included, capping exposure to sectors or regions, or even building different allocations between developed and emerging markets.

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The environment for pricing fixed income instruments is even more difficult in Europe than in North America. In the US, all trades involving investment-grade, high-yield and convertible corporate bonds must be reported to the Trade Reporting and Compliance Engine (Trace), so transaction prices, where they exist, are publicly available. This means it is possible to offer a real-time pricing service.

In Europe, by contrast, there is no single price-publication platform, and no obligation to report trades.

"There needs to be some mechanism that makes prices freely available," says Christos Costandinides, an independent exchange traded fund consultant.

With vanilla bonds, at least, there is no obstacle to prices being published. More exotic instruments can be less transparent. Leveraged loans, for example, are the basis of some liquid indices in the US, but such an index would be impossible in Europe.

"In Europe, contracts for leveraged loans specifically forbid price sharing," says Mr Costandinides. "That is the problem we are facing."

Although regulators are aware of this issue, it is quite far down their long list of priorities, he adds. "Regulators are always working to make things better, but I do not see any game-changers coming up. We have not had a big accident yet, so it does not seem urgent."

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