By Scott Harman, global head of fixed income and multi-asset index product management, and Nikki Stefanelli, global head of fixed income and multi-asset index policy
The impact of inclusion of a country's bonds in a flagship local currency government bond index, is naturally of great interest for issuers and investors alike. An accurate overview allows market participants to anticipate corresponding asset flows and allows issuing governments to more accurately assess the impact to their local capital market of an inclusion event.
A recent case, which illuminates the impact of inclusion, is that of Israel. Israeli local currency government bonds were the first to graduate to FTSE World Government Bond Index (WGBI) through the FTSE Fixed Income Country Classification Process, which was introduced in January 2019. Having now been included to the WGBI for roughly six months,[1] we thought it was an appropriate juncture to review the implications to the local market with respect to foreign exchange rates, international inflows and shifts in holding distributions, as well as approaches to managing a government bond market portfolio. More broadly, this highlights the importance of market evolution for flagship global bond indexes and the importance of introducing diversity through a transparent, rigorous and rules driven framework.
Non-resident holding patterns as a proxy for index-linked assets
It is often difficult for index providers to pinpoint the exact number of assets tracking an index. FTSE Russell relies on public databases such as Morningstar and eVestment to collect data on publicly reported funds. However, this tends to understate the actual assets tracking an index given that often, separately managed accounts, central banks and sovereign wealth funds do not necessarily report their government bond holdings to public sources. Therefore, levels of foreign flows to a local market around an index inclusion are a useful data point for back-of-the-envelope estimates. Given their infrequency, however, we are keen to study such behavior to glean a better understanding of the impact of bond market inclusion to WGBI.
At the time of inclusion for May 2020 profiles[2], 14 ILS-denominated government bonds with $74.7 billion in market value were included to the FTSE WGBI comprising 0.32% of the index in a market value weighted basis. According to the Bank of Israel, percentages of holdings of tradable government bonds by non-residents increased from 5.2% in April 2020 (~$8.3 billion) to 6.9% (~$12.0 billion) in August 2020, representing an approximate $3.67 billion in non-resident inflows. While these figures are not disclosed with granularity across government asset classes and therefore could also potentially include some inflation-linked foreign inflows, we assume that they are mostly fixed-rate government bond securities attributable to the index inclusion event.
As expected, and shown in Figure 1, we see the largest increases in non-resident ownership in the month of May, the first month of index inclusion, with a smaller increase in June, followed by a leveling off in July and August. Investors will tend to add inclusion initially with on-the-run bonds, and then build their exposure with other tenors of a given local market curve, but the approach can certainly vary based on a given fund’s objectives, size and geographic presence.
An approximate $3.7 billion inflow and 0.32% weight in the index would correspond to approximately $1.15 trillion in assets passively tracking. Anecdotally, we know that this type of analysis is imperfect as it tends to understate assets tracking as it does not precisely capture active funds or investors who look to replicate exposure with the ILS currency or other non-physical positions.
Implications of local market index inclusion for foreign exchange market
In addition to studying the foreign inflows to the bond market that result from index inclusion, market participants and government issuers are keen to understand the extent to which a local currency may also appreciate in response. A critical aspect of a local government’s market accessibility for international investors is its foreign exchange market structure, since non-resident investors will need to source the native currency to purchase local currency-denominated government bonds. Additionally, fixed income portfolio managers closely manage their foreign exchange exposures as currency return can form a significant portion of total return for global bond funds. It is difficult to attribute any appreciation of the ILS versus the US dollar to index inclusion and inflows tend to not have a significant impact on the local exchange rate, as the level of inflows are small relative to other balance of payment activities.
In advance of index inclusion and through implementation of country inclusion changes, we can work closely with local market participants across a range of functions—asset managers, regulatory bodies, broker dealers, local exchanges—to ensure that the local infrastructure is able to absorb the impact of any changes with as little friction as possible. Such engagement allows us to thoughtfully reflect on the implications of such index changes and continue to support local markets through these types of transitions. This is especially relevant in light of our recent FTSE Fixed Income Country Classification September 2020 Review results announcement, which communicated a pathway for the inclusion of China Government Bonds in the WGBI[3]—an inclusion event that is likely to focus attention on the same dynamics as described for Israel’s inclusion.
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[1] ILS-bonds were added effective with the May 2020 profiles.
[2]As of October 2020, 15ILS-denominated bonds with $83.4 billion in market value are included in the FTSE WGBI comprising 0.34% of the index on a market value weighted basis.
[3] For more information on our latest FTSE Fixed Income Country Classification Review, please see: http://www.yieldbook.com/m/indexes/FTSE-indexes/message.shtml?id=300.
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