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Considerations for designing a fixed income country classification framework

By: Scott Harman & Nikki Stefanelli, Benchmarks

In their simplest sense, benchmarks define peer groups: peer groups of investments by asset class (fixed income vs equities; government vs corporate); by industry (industrial vs financial); by country (developed vs emerging), and so on. And there are endless possible permutations thereafter. The method by which this grouping or classifying is achieved has been fundamental to the evolution of many established and widely used benchmarks.

The classification process for countries employed by FTSE Russell global equity indexes, for example, is a transparent and evidence-driven process, which ensures that country classification is judged objectively and meets the needs of index users. At first glance, one could envisage the same rigorous and transparent criteria could also be applied to fixed income benchmarks. However, doing so would ignore important idiosyncrasies with fixed income that warrant a more tailored approach.

In the global equity index world, a clearly defined graduation pathway for individual countries to progress from frontier through to developed classifications exists. Conversely, in the fixed income world, credit quality tends to supersede formal emerging market definitions, creating what are commonly referred to as “crossover markets” within flagship investment grade, multi-currency benchmarks for global portfolios. Benchmarks such as the FTSE World Government Bond Index (WGBI) are comprised of high credit quality government bond markets that are generally considered developed but have overlap with dedicated emerging markets benchmarks such as the FTSE Emerging Markets Government Bond Index (EMGBI). Examples of such crossover markets currently include South Africa and Mexico. Indeed, within fixed income benchmark design, the distinction between emerging and developed markets is blurred by high credit quality emerging markets. The concept of graduating from an emerging to a developed fixed income index is therefore less applicable. This is broadly an accepted feature of the fixed income market.

Given the breadth of issuers and structures within the fixed income markets, benchmark peer groups are further sub-defined, creating a level of granularity that does not exist for equities: fixed vs floating rate securities; corporate vs government bonds; and so on. Inclusion of a country’s local debt market into broad-based multi-sector benchmarks, such as the FTSE World Broad Investment-Grade Index (WorldBIG®), will incorporate considerations for which asset classes and sectors should be included once a currency becomes eligible.

This is particularly relevant for smaller local currency markets and emerging market crossover markets where determinations must be made around whether investment grade corporate, quasi-sovereign and securitized issuance in a given local currency are appropriate for inclusion. Historically, the inclusion of multiple sectors within broad-based multi-sector fixed income indexes has been somewhat opaque, with the process and criteria for assessing inclusion of local currency corporates, for example, not generally clearly articulated. The remarkable liberalization of the Onshore China fixed income market is an excellent example of the complexity of local market inclusion within global multi-currency and multi-sector indexes. Most attention has focused on the eligibility of treasury and policy bank bonds, but less thought has been given to other sizeable and vibrant sectors that are increasingly being rated by global credit rating agencies. Indeed, fixed income sub-asset classes can exhibit idiosyncrasies that may mean recalibrating either the market size, credit rating or market accessibility criteria across distinct flagship multi-currency benchmarks. For example, central government issuance patterns of inflation-linked debt can vary greatly from its issuance of nominal debt.  

Lastly, unlike stocks, fixed income instruments are generally not exchange listed. This means the quality and sourcing of pricing can present challenges for certain markets and must be formally considered as part of the country inclusion framework.

Despite these caveats, there are country classification considerations across equities and fixed income that share many features: a country’s regulatory environment, foreign exchange market, and dealing landscape are just some of the issues that will apply for both frameworks.

The FTSE Country Classification framework is a transparent reference point for index users to assess the eligibility of equity markets across the full global spectrum of country classifications, spanning frontier to developed markets. The framework is also beneficial to policy makers to be able to discern and address deficiencies in order to graduate through the equity country classification spectrum. Historically, fixed income index providers have tended to address new local currency market or “country” inclusion into broad-based global benchmarks on a case by case basis without applying a consistent and transparent framework for evaluation. Our goal as a multi-asset index provider is to draw inspiration from the equity country classification process to create a transparent framework for fixed income index users, while at the same time acknowledging and preserving the clear and important differences between the two asset classes.    

 

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