What is meant by the duration problem associated with a market-cap-weighted bond market index?

Question

What will be an ideal response?

Answer 1

At a theoretical level, the justification for using a market-cap-weighted bond index is provided by capital market theory. According to this theory, if markets are price efficient, then the best way to capture the efficiency of the market is to hold the market portfolio that is a market-cap-weighted portfolio, precisely what a market-cap-weighted bond index purports to represent. However, there are problems associated with such indexes from an investor's perspective and one of these is the "duration problem."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. More details are given below.

The duration problem was identified by Laurence Siegel in 2003 . Siegel noted that issuers of bonds make a decision as to the duration of the bonds that they issue and their decision is based on minimizing their funding costs. However, when investors make duration decisions, it is based on maximizing total return given their investment objectives. There is no reason to believe that there will be any consistency between the cost minimization objective of issuers and the return maximization objective of investors in the determination of the duration in the market. As a result, Siegel refers to the duration that is obtained from an index as a "historical accident."

This can be put into perspective by looking at the market risk exposure for an equity market index. Beta is the measure of market risk exposure for a stock, stock index, and stock portfolio. An equity market index has a beta that is one and thereby represents sort of a neutral position. In contrast, for a bond market index there is no neutral position that is determined by investors. The duration is, as noted by Siegel, just a historical accident; instead, duration should be an active decision made by a portfolio manager (or client) and not dictated by a bond market index.

Equally weighting does 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.