Market cap based passive investment strategies are supported by theory and appear to function well in many equity markets. They also appear to work for fixed income markets but here their track records are shorter and not so well supported by logic. The market cap approach directs flows towards the largest borrowers who are not necessarily those best positioned to honour their obligations.
A further issue is that the technical aspects of the way bonds are priced can have profound implications for the risk characteristics of the indices. The impact of the secular fall in interest rates has impacted prices of longer dated gilts far more than those with a shorter time to maturity. Gilts are typically issued around the par price of 100. Today, there are two high coupon long dated gilt bonds which are priced at over 200. As a result, the weighting of these two issues in the index is approximately twice that of when they were originally issued. Falling bond yields pushes out the average duration of the index (ceteris paribus).
The chart above details the startling lengthening of duration risk within the index over the last 10 years. The rise in the duration has come about through a combination of DMO issuance trends and the impact of falling yields on prices. This has lifted the interest rate sensitivity of the index by 40% over the period. It is probable that the interest rate sensitivity of the index will peak when bond yields reach their secular low.
The impact on the smaller index linked gilt market has been even more profound. Today, the average duration in the linkers market is over 22 years, having doubled over the last decade. Prospective volatilities of linker trackers are moving towards those of equities. Buyers of index products be warned.
Advisers using portfolio modelling services offered by the likes of DT, eValue, B&H etc. should consider how this might impact their portfolio construction. Many of these modellers base their forecasts around the historic behaviour of bond indices. We are unsure to what extent their assumptions reflect the changing risk profile of the gilt indices.
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