The construction of GLADI follows three steps: (1) regional weights are assigned based upon the relative GDP shares of the respective major regions in the global economy, (2) factor/instrument category weights are identified based upon the primary sources of fixed income risk/return available to global investors within each region, and (3) security selection within each sub-index is guided by a set of rules and a market profile process designed to ensure that the index is investable and can be replicated in a portfolio of liquid securities. Figure 3 illustrates the process.
Figure 3: Three steps in constructing GLADI
Step 1: Assign regional weights by gross domestic product
Major Regions Weighted by Share of Global GDP
- United States
- Other Industrialized Countries
- Emerging Markets
Step 2: Assign instrument category weight by key sources of fixed income risk and return
Balance of Instruments to Represent Key Sources of Fixed Income Return
- Interest Rate Duration
- Interest rate swaps (nominal)
- Inflation-protected securities (real)
- Credit Premiums
- Investment grade corporate bonds
- External sovereign bonds
- Securitized Instrument Premiums
- Mortgage-backed securities and covered bonds
Step 3: Complete security selection for each sub-index based upon eligibility criteria and market profile Security
Selection Designed for Replicability and Investibility
- Eligibility Criteria
- Credit quality
- Instrument type
- Minimum remaining maturity
- Minimum par outstanding
- Market Profile Process
- Select set of liquid securities to represent maturity and industry profile of broader market
The regional classification distinguishes the major economic regions listed in Figure 3, with the weight of each region in GLADI determined by its respective share of global GDP. GDP shares are calculated as the simple average of each region’s share of global GDP for the previous five years, measured in nominal U.S. dollars at market exchange rates. The GDP data come from the International Monetary Fund. GDP weights are revised annually, with the new weights becoming effective on 31 October of each year. Figure 4 displays the current regional target weights for GLADI, based on the annual review that became effective on 31 October 2015.
Step 2: Instruments weights and sub-index target weights
As discussed above, market capitalization weighting has the disadvantage of increasing the weight of securities as they become more expensive. In addition, market capitalization-weighted global indexes tend to be dominated by government bonds because of their large historical issuance, despite the fact that many bond managers tend to use other instruments, such as interest rate swaps, as a substitute for the interest rate duration that comes from government securities.
To avoid these issues, GLADI takes a different approach, employing a proportional weighting system based on the key sources of fixed income risk and return. Of particular importance are: (1) interest rate duration, reflecting the sensitivity of bond prices to changes in nominal and real yields; (2) credit premiums, reflecting the higher yields available on securities with credit risk; and (3) securitized instrument premiums, reflecting embedded pre-payment options and other premiums associated with mortgage-backed securities. In the absence of a robust theoretical or empirical rationale for departing from a parsimonious equal weighting of each of these factors, this is adopted as the preferred weighting scheme.
The implementation of Steps 1 and 2 is illustrated in Figure 5, where each respective region’s GDP weight (Column A) is multiplied by the proportional instrument category weight (Column B) to produce the 17 sub-index target weights(Column C).
For the United States, the eurozone, and other industrialized countries, the application of this framework is straightforward: the 1/3 interest rate duration component is represented by a mix of two parts interest rate swaps and one part inflation-protected securities; the 1/3 credit premium component is represented by fixed-rate corporate bonds; and the 1/3 securitized instrument premium component is represented by U.S. Agency mortgage-backed security TBAs, mortgage-backed bonds in Canada and Denmark, and covered bonds and Pfandbriefe in the eurozone, Sweden, Switzerland and the United Kingdom.
In other markets, adjustments to this methodology are incorporated to reflect the availability of certain categories of instruments.
For Japan, where liquidity in the corporate bond market is highly limited and there is no substantial securitized market, only the interest rate duration component is included.
For emerging markets, the lack of liquid interest rate swap markets means that internal local currency-denominated government bonds are used to represent the interest rate duration risk factor, while U.S. dollar- and euro-denominated external sovereign bonds are used to represent credit premiums. Due to the lack of widespread securitized markets at this time, this category is not represented for emerging markets. However, because short-duration local currency investments have become a staple of global investment in these markets, currency – represented by short-dated foreign exchange derivatives – is included as a separate category.
Step 3. Security selection
The final step is to determine the specific securities that will be included in each of the sub-indexes.
The universe of potential securities is defined by a series of eligibility criteria. In order to preserve replicability and investability, the number of securities selected within each market is limited, depending on the size of the market and liquidity considerations. When the actual number of securities in the market exceeds the limit, a market profile process is applied to select the securities that will be included in the index. The market profile process refines the universe of eligible securities to identify the most representative and liquid securities, producing an index that is replicable and investable.
A. ELIGIBILITY CRITERIA
- Credit quality. Eligible instruments must be investment grade (BBB- or higher). The average rating from Moody’s, S&P and Fitch is considered when available. Instruments downgraded to below investment grade are removed from the index upon monthly reconstitution.
- Instrument type. Outside of derivatives instruments, only fixed-rate, non-callable (except for mortgage-backed securities) bullet bonds or sinking funds issued by developed and emerging governments, corporations and securitization entities are eligible.
- Remaining maturity. All emerging market, inflation protected, corporate and securitized bonds must have at least 12 months remaining until maturity. Securities with maturities of less than 12 months upon monthly reconstitution are excluded from the index.
- Minimum par amount outstanding. Eligible instruments must have a current par amount outstanding greater than or equal to a minimum amount that differs by instrument and is currency specific. Minimum par for inflation-protected bonds is 2 billion USD or the approximate foreign currency equivalent. For corporate bonds, the minimum is 500 million USD, 100 million GBP or 300 million CAD, EUR, AUD or CHF. Securitized bonds must have a minimum par of 1 billion CAD or EUR, 100 million GBP, 300 million CHF, 2 billion SEK or 3 billion DKK. For emerging markets, the minimum for external bonds is 500 million USD or EUR, while local bonds must have a minimum local currency equivalent of 100 million USD.
B. MARKET PROFILE
The market profile process is used for the corporate, securitized and emerging market local bond sub-indexes of GLADI. The objective of the process is to create an index that is replicable and investable by identifying the most representative and liquid bonds in each sector of the market.
The market profile process for each sub-index varies depending on the particular attributes of that sector, but the basic process involves three steps, illustrated in Figure 6 with an example from the U.S. corporates sub-index.
1. Create a market structure matrix, which classifies all bonds according to the most relevant factors in that market.
2. Calculate the number of bonds to be selected for the market profile for each cell by multiplying the cell’s market share by the overall target number of bonds for the sub-index.
3. Select the highest-ranked individual securities (based on a set of ranking criteria – see box inside Figure 6), until the target number of bonds per cell is satisfied. Only one bond per issuer is considered in each cell until one bond from each issuer represented in that cell has been selected. If the number of bonds required is larger than the number of issuers, a second bond is selected from each issuer according to the rank until the required number of bonds has been selected.
Streamlined market profiles are also used for the interest rate swap and emerging market foreign exchange components of the index. A basket of 2-year, 5-year, 10-year and 30-year swaps are used to represent the interest rate swap sub-indexes, while a basket of 1-month, 2-month and 3-month foreign exchange forwards are used to represent the emerging market currency sub-index.
Figure 6: Market profile example: U.S. corporates
1. For U.S. corporates, the relevant factors are industry sector and maturity. Bonds are assigned to cells in the matrix based on their sector (senior financial, subordinated financial, non-financial consumer and non-financial industrial) and maturity band (1-7 years, 7-15 years, 15+ years). In this example, 6% of the total market value of the U.S. corporate universe is in the cell corresponding to financials with 7-15 years maturity.
2. Calculate the number of bonds to be selected for the market profile for each cell by multiplying the cell’s market share by the overall target number of bonds for the sub-index. The overall target number of bonds for the U.S. corporate sub-index is 500. Using the example above where financial sector bonds of 7-15 year maturity represent 6% of the universe, 30 bonds should be selected for this cell (500 x 6% = 30).
3. For this example, bonds issued within the last five years would be the first considered for index inclusion, with these bonds ranked based on 1) the amount outstanding, 2) time since issue, 3) remaining time to maturity and 4) issuer size.