By Lydia Hamill and Monika Arya, Senior Associates, Fixed Income and Multi-Asset Index Product
When the first fixed income indexes were developed decades ago, they were constructed with a clear distinction between short-term and long-term exposure. But, in more recent years, this distinction created problems for some passive investors, resulting in benchmark turnover and higher transaction costs.
The initial reasons behind making the distinction were structural—at the time, fixed income trading desks were designed to accommodate them separately. But the fixed income trading landscape has since evolved significantly, calling this traditional benchmarking rule into question. At the same time, an uncertain market environment and rising inflation expectations are spurring increased demand for shorter-duration fixed income exposures.
How tradition became antiquity
Many of the first fixed income indexes were constructed on the trading floors of investment banks in pursuit of trading volumes. Trading was structured such that money market instruments and longer-term exposures traded at different desks, and with different customers. The logic behind the separation related to trading behavior—once longer-term bonds fall below one year to maturity, prices tend to align with par and there’s very little price performance.
However, the industry has since evolved considerably, and is now challenging this long-held distinction. The vast majority of fixed income businesses have been sold to data providers, and intensified downwards pressure on trading costs and fees have made for much lower tolerance of excess turnover in the benchmark—a by-product of bonds exiting at the one year to maturity mark.
The turnover problem
When indexes are restricted to including bonds with a minimum of one-year maturity, monthly index rebalances force passive investors to sell bonds as their maturity breaches the one-year mark. If they don’t, they face increased tracking error relative to the benchmark, a metric often used to measure effective benchmark tracking. However, including money market instruments with maturities of less than one year in fixed income indexes solves for this, as it enables passive investors who prefer to hold bonds to maturity to do so without force selling.
The maturity rule impact on turnover is evident when comparing our flagship FTSE World Government Bond Index (WGBI) with our newly launched FTSE World Government Bond 0+ Years Index (WBGI0+). The flagship index tracks liquid, investment-grade sovereign bond markets with a minimum of one year to maturity, while the new index is a reproduction without the minimum maturity threshold.
As shown below, during the heightened volatility at the onset of the pandemic crisis, the WGBI0+ exhibited lower turnover than the WGBI for almost every month throughout the period, with the notable exception of April 2020 when we postponed rebalancing for all indexes in the wake of the crisis.
Rising demand for money market products
Amid a growing intolerance for excess turnover costs, the macroeconomic backdrop is also giving rise to stronger demand for money market and short-term products. Heightened market uncertainty and inflation expectations have made duration hedged investments particularly attractive, as investors seek shorter-duration exposures in their flight-to-safety. Shorter duration government securities have lower interest rate sensitivity and tend to carry less credit risk, offering relatively low but safe returns in turbulent markets. Unsurprisingly, total net assets in money market funds grew 21.7% over the year ending December 2020—the highest increase in the last 5 years.
Evolving our indexes to align with the new paradigm
At FTSE Russell, we recognize this rising demand and believe that our fixed income indexes must evolve with the market to continue serving as an efficient basis for passive investments. As such, we’ve extended the FTSE US Treasury 0-1 Year Index construct across all FTSE WGBI sovereign bond markets. We’re also planning to make the 0-1 year maturity bucket standard across all FTSE fixed income indexes—reflecting evolving fixed income index design in an ever-changing fixed income market.
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 Please note that FTSE WGBI0+ only launched in June 2021, so index history is not impacted by the postponed rebalance. For more details around the rebalance postpone, please see the notice.
 Morningstar Inc., data as of December 31, 2020, Worldwide OE, MM & ETF ex FoF ex Feeder, Exclude Obsolete Funds, Global Broad Category Group: Money Market.
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