Does an issuer-capped bond index overcome the duration problem associated with a market-cap-weighted bond index?
What will be an ideal response?
The duration problem refers to the conflict that exists between bond issuers and bond investors with respect to the duration of bonds issued and the resulting duration for the bond market index. An issuer-capped bond index associated with a market-cap-weighted bond index does overcome the duration problem. Below we discussin more details the difficulty of overcoming the duration problem.
We can begin by pointing out that equally weightingdoes not address the duration problem. The empirical question is how equally weighted bond indexes perform relative to market-cap-weighted bond indexes in terms of risk and return. Using the Sharpe ratio as a measure of return relative to risk, one study finds that the Dow Jones Equal Weight U.S. Issued Corporate Bond Index outperformed market-cap-weighted corporate bond indexes. A company's fundamentals are its characteristics such as cash flow, book-to-value ratio, dividend per share, sales growth, and the like. In the equity market, indexes have been created where the weight assigned to a company in the index is based on a set of company fundamentals. The resulting index is called a fundamental index. As with equal weighting, a fundamental bond index does not address the duration problem. Another corporate bond index proposed by Research Affiliates that is a blend of equally weighting and a market-cap weighting scheme is based on the face value of debt rather than on market value. This weighting scheme also does not address the duration problem.
A risk-weighted Treasury index that has a laddered maturity of Treasury issues was created jointly by Ryan ALM and Mergent, the Ryan/Mergent U.S. Treasury Ladder Index Family. The 30 Treasury issues in the index are equally weighted fixed-coupon U.S. Treasury issues, with one issue maturing each year for 30 years. The duration problem is not eliminated with this index scheme but it is mitigated because the average index duration will fluctuate much less widely compared to a market-cap-weighted bond index.
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