State Street Global Advisors (SSgA), the investment management business of State Street Corporation (NYSE:STT) has launched two new fixed income strategies based on alternative-weighted indices that are designed to forecast a company’s financial strength. They also exclude debt issued by private companies and subordinated debt.
The SSgA US Issuer Scored Corporate Bond Index strategy and the SSgA Euro Issuer Scored Corporate Bond Index strategy both seek to track a new and innovative benchmark index design. These indices use financial factors to weight the allocation to corporate bond issuers based on profitability, operational efficiency, leverage and liquidity. This is achieved by focusing on return on Assets (RoA), interest coverage and current ratio. The indices seek to maintain similar sectoral characteristics as traditional benchmarks, but with lower volatility and improved risk-adjusted returns. The benchmarks used for the two new SSgA strategies are the Barclays Capital US Issuer Scored Corporate Index and Barclays Capital Euro Issuer Scored Corporate Index.
SSgA research contributed to the development of the indices and the company has a two year exclusivity to manage passive strategies against the Barclays Indices.
Kevin Anderson (pictured), global chief investment officer for Fixed Income and Currency at SSgA says: “The issuer scored corporate index expands the fixed-income market exposure toolkit to investors by providing a solution that addresses concerns about the risk posed to a portfolio by the underperformance or default of a single issuer or small group of issuers – idiosyncratic risk. It does this by re-allocating capital to companies based on trends in financial strength in contrast to a traditional market cap weighted approach.
“By using an index to encapsulate the reweighting methodology we believe that investors maintain transparency of a clear set of rules governing their corporate bond exposure on which they can base their asset allocation decisions. This exposure can then be managed using a robust passive process whilst still forming a better fit to some investors needs from corporate bond allocations.
SSgA Research Reveals Benefits of Issuer Scored Corporate Bond Indexing.”
Most major indices are capitalisation weighted, ranking index constituents by size. For fixed-income investors, following these indices means allocating larger amounts of their capital to the institutions with the most debt.
SSgA researched the alternative-weighted concept for corporate bond indices and found that this approach can potentially achieve better index returns versus a cap-weighted index but with lower volatility. The research contributed to the creation of a new alternative-weighted index, the Barclays Capital Issuer Scored Corporate Index (ISCI), which re-weights corporate indices in the US Dollar and Euro based on three factors: return on assets (ROA) and interest coverage or current ratio.
SSgA’s analysis concluded that it is possible to construct an index-based portfolio that quantitatively re-weights a corporate universe by ranking or ‘scoring’ the issuers based on the trend of a company’s financial strength. Crucially, by translating SSgA research into the construction of an index, this approach preserves all of the primary benefits of passive investing, which are transparency, cost, efficiency and diversification. ISCI does not aim to avoid issuers that score low, rather, it seeks a broader deployment of capital among all the constituents, not simply the big ones. If the index sought to screen for only the companies that rated the best, the result would be something akin to a triple-A rated index, which neither provides the yield nor diversification required by investors.
With ISCI, greater capital is allocated within each sector to those issuers that generate the highest financial scores in terms of improvement of their return on assets and interest coverage. From an idiosyncratic risk standpoint the risk is more evenly distributed among the issuers than in a traditional cap weighted index.
Analysis by SSgA reveals that between January 2005 and October 2010, the SSgA Issuer Scored Corporate Bond Model Index would have delivered 0.94 percent more in annualised interest than the Barclays Capital US Corporate Index*. Furthermore, between January 2005 and July 2007, which was a period of low volatility, it would have delivered a superior annualised return of 0.56 percent. Similarly between August 2007 and October 2010, which was characterised by high volatility, it would have outperformed on an annual basis by 1.09 percent.
Anderson says: “Looking ahead, we believe idiosyncratic risks will rise for fixed-income investors. Fixed income has delivered exceptionally well as an asset class, but with rates again coming into historic lows, there is heightened potential for rising volatility ahead. In this environment, we see the potential for some winners and losers. By redistributing the weights of a corporate index based on trends in financial health, investors can potentially reduce the chances that deterioration of specific issuers with worsening financial trends will significantly impact either the index returns or more importantly actual portfolio returns using this index as a benchmark.”