Bond indexation serves the purpose of replicating the performance of a predetermined benchmark as closely as possible. These benchmarks are generally very broader in terms of number of bonds encompassed. For example, in countries like US and Europe, the most common indices include several thousands bonds. Further, the turnover on indices is substantially quite large. This is because of substantial proportion of the bonds maturing each year and significant amounts being issued each year. Very frequently, large segments of bond market behave illiquid. Hence, futures on bond indices are currently a rare phenomenon. In general they are based on notional bonds.
Now, let us discuss about indexing technology. In this section, we will focus on stratified and optimization sampling techniques.
Stratified Sampling: Stratified sampling aims to limit the number of bonds included in the indexed portfolio and also avoid trading too small bond positions. In addition, it also tries to avoid being in the illiquid segment of the market. Under stratified sampling, an indexed portfolio is constructed through following below given steps:
Initially, the universe of bonds in the benchmark is divided into cells on the basis of certain characteristics of bonds. The characteristics include coupon, term to maturity duration, quality rating and sector etc. Subsequently, the weight of each cell is determined given the weights of bonds in the benchmark.
In the second step, for each cell with non-zero weight, a limited number of bonds belonging to the cell are selected and a price weighted portfolio is created. This portfolio matches as closely as possible some of the average characteristics of the cell such as its average duration, convexity etc., and holds appropriate weight in the indexed portfolio.
In case of bonds, the rationing in the number of bonds comes from the explicit limit the indexer imposes while building a bond portfolio for each cell.
Optimized Sampling: Optimized sampling overcomes the drawbacks of stratified sampling approach. It has the following advantages.
It provides an ex-ante measure of the tracking error of the indexed portfolio with regard to benchmark.
It gives access to an optimizer, which facilitates construction of a portfolio by considering the risk trade-off between factors and the transaction costs.
It allows the indexer to choose the level of tracking error to be achieved by limiting the number of bonds in the indexed portfolio.