Bond indexes and how they differ from equity indexes

How is a bond index different from a stock index?

A bond index does the same jobs as a stock index: it measures market performance, benchmarks managers and funds, and underlies index funds. It differs in three ways.

	Equity index	Bond index
Constituents	One or two lines per company; hundreds to a few thousand	Every eligible bond of every issuer; some indexes have more than 10,000
Turnover	Low; changes with listings, delistings and reviews	High: bonds mature and new issues arrive; usually rebalanced monthly
Weighting	Market capitalization of equity	Market value of debt outstanding, so big borrowers (often governments) weigh most
Replication	Full replication often possible	Usually a representative sample

More turnover comes from two sources: every bond has a finite life, and issuers keep selling new bonds. Bonds that fall under the minimum maturity, rating or size are removed at each rebalancing , and new issues are added.

An index fund cannot practically buy every one of 10,000 or more bonds, many of which rarely trade. It uses representative sampling : a smaller set of bonds chosen to match the index’s duration, credit mix and sector weights.

A broad bond index also drifts with the market. If governments borrow more, issuers move to longer maturities or average credit quality slips, the index shifts too.

How is a bond’s index weight calculated?

Market value weighting means each bond counts for its share of the total market value of debt in the index. Market value is par outstanding times price, divided by 100.

$$w_i = \frac{\text{Par}_i \times P_i / 100}{\sum_j \text{Par}_j \times P_j / 100}$$

What kinds of bond index exist?

Aggregate index means a broad index across many sectors and currencies. A typical global aggregate holds fixed-coupon investment-grade bonds of sovereign, government, corporate and securitized issuers in dozens of currencies. It applies a minimum issue size, requires at least one year to maturity, rebalances at each month end and reinvests cash flows at the next rebalancing. High-yield and unrated debt is left out.

Narrow indexes slice the market. The cut can be sector (corporates), credit quality (high yield), maturity (short-term), geography (one country, or emerging-market sovereign debt in US dollars) or an ESG screen.

Fixed-income indextracks a group of bonds that meet its inclusion rules

• Aggregate (broad) Use it many sectors and currencies, investment grade, minimum size, at least 1 year to maturity
• Narrow Use it one slice of the market
  • Sector for example corporates only
  • Credit quality for example high yield
  • Maturity for example short-term
  • Geography one country; emerging-market USD sovereigns
  • ESG screen minimum ESG rating, excluded activities
• Return basis Know the idea for multi-currency indexes
  • Unhedged includes currency gains and losses
  • Hedged currency effect offset with forwards

An ESG screening index applies a minimum ESG rating and excludes certain activities, such as tobacco or thermal coal, on top of the usual rules. A sustainable euro corporate index, for example, keeps only euro investment-grade corporate bonds that pass the screen.

Multi-currency indexes report hedged and unhedged returns . Unhedged returns include currency gains and losses. Hedged returns use currency forwards at each rebalancing date to offset them.

Choose the index that matches the fund. A fund of short-term investment-grade bonds should be judged against a short-term investment-grade index, and a fund that invests in one country against that country’s index.

Go deeper Why governments dominate debt-weighted indexes

Weighting by debt outstanding rewards heavy borrowers. A government that issues more gets a larger weight, so an index can end up with its biggest positions in the most indebted issuers. That criticism is why some investors prefer other weighting schemes. The standard exam answer remains market value of debt.

Go deeper Emerging-market sovereign indexes in US dollars

A narrow index of emerging-market government bonds issued in US dollars usually targets lower credit quality and a minimum issue size. It aims for higher dollar returns than developed-market sovereign bonds, in return for the issuing country’s external-debt risk. It excludes bonds whose payments are linked to an exchange rate.