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Global Advantage Bond Index

Key Documents

PIMCO created the Global Advantage Bond Index (GLADI) to provide investors with an investment-grade fixed income benchmark that we believe more accurately reflects the rapidly-changing dynamics of the global investment universe than traditional indices. Employing an innovative investment framework that focuses on GDP rather than market capitalizations, GLADI strategically orients away from the ever-increasing number of economies saddled with heavy debt burdens and serves as a building block for portfolios with the potential for higher risk-adjusted returns.

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New Approach to Bond Indexing

The global economy is in the midst of dramatic transformations that challenge the ability of traditional investment approaches to generate sustainable returns while also managing risks. One profound change crucial to bond investing is the explosion of public debt levels in industrialized countries. Traditional bond indexes - by virtue of their market capitalization weighting methodology - have an inherent structural bias to overweight countries with high levels of debt. As concerns about sovereign creditworthiness become increasingly critical to asset allocation, there is greater urgency for an alternative to traditional approaches.

Through its broader coverage and unique construction methodology, GLADI explicitly recognizes the need for investors to position their fixed income portfolios within this changing global environment. Several core features distinguish GLADI from traditional fixed income indices, including:

GDP 

An innovative GDP-weighting methodology that avoids the disadvantages of traditional indexes based solely on market capitalization weighting.


Emerging Markets 

A continuum in coverage from developed to emerging markets, capturing the fuller set of global investment-grade opportunities and avoiding a lopsided weighting toward developed markets.


Inflation 

Inclusion of inflation-linked bonds in addition to nominal bonds, providing a partial built-in hedge against potential inflationary pressures.


Inflation 

A global beta that evolves with the world’s economic structure, providing broad exposure to a diversified basket of global currencies, especially currencies of creditor countries in the emerging world.


Advantages of GDP Weighting

GLADI weights index components based on gross domestic product (GDP) as an alternative to the market capitalization weights used by most existing fixed income indexes. GDP weighting offers a number of relative potential benefits:

1. Higher Allocation to Low-Debt Countries. Because larger stocks of debt mean higher market capitalization, market capitalization-weighted indexes are at a structural disadvantage as they have a bias to assign greater weights to highly indebted countries, even though the credit quality of those issuers may be eventually compromised by their debt load. In contrast, GLADI’s GDP-weighted approach bases allocation on national income (GDP), which embodies the capacity to repay debt. The income-orientated approach produces a bond beta with an emphasis on countries with lower leverage, or lower levels of debt relative to their ability to service the debt, as illustrated in Figure 1.

2. Forward-Looking. Fundamental transformations in global capital markets are reshaping the financial landscape for retail and institutional investors. Market capitalization-weighted indexes fail to capture these changes because they are inherently backward-looking, reflecting past patterns of debt issuance. Since rapid economic growth tends to precede the liberalization and deepening of capital markets, GLADI’s GDP weighting is designed to capture the opportunities that exist in the world’s most dynamic economies. By embedding a concept of where capital markets will be in the future – rather than where they have been in the past – GLADI helps investors position their portfolios to reap potential first-mover benefits.

3.Counter-Cyclical Rebalancing. Another well-known disadvantage of market capitalization-weighted indexes is that they assign progressively greater weight to securities as they go up in price, exactly the opposite of the investment maxim to “buy low, sell high.” GLADI not only is designed to avoid this pitfall of market capitalization weighting, but also has the potential to benefit from counter-cyclical rebalancing, since bond prices tend to move inversely to GDP growth over the business cycle, with bond prices rising as economic growth slows, and falling as economic growth accelerates. A GDP-weighted index that increases the relative weight of countries in the expansion phase of the business cycle (when bond prices are low) and reduces the relative weight of countries in the contraction phase (when bond prices are high) helps embed a “buy low, sell high” bias, as illustrated in Figure 2. 

Methodology

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.

Step 1. Regional Weights

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 2012.

Step 2. Instrument 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 eurodenominated 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

There are four eligibility criteria that define the universe of instruments:

  • 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 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), 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.

Index Attributes

 

The index methodology described above produces an index that is broadly diversified across instruments, regions, currencies and maturities. Key attributes of the GLADI overall index and sub-indexes are presented in the accompanying figures. Figures 7 through 11 show index data as of 31 October 2012.

GLADI is diversified across a full spectrum of markets, sectors and instruments – from developed to emerging markets, nominal to real assets, and cash to derivative instruments.


 
 

Re-weighting & Rebalancing

Target Regional weights for GLADI will be revised in an annual review, with the new weights becoming effective on 31 October of each year. Under most circumstances, year-to-year changes in the sub-index target weights will come only from changes in the regional weights, which will shift as relative shares of global GDP shift. On occasion, the instrument category weights may also be changed at the annual review to reflect the development of new instrument categories and other innovations in global capital markets.

The actual weights of the GLADI sub-indexes on a daily basis will deviate from their target weights, reflecting changes in the prices of the underlying instruments in the index. On a quarterly basis (31 October, 31 January, 30 April, 31 July), the GLADI will be rebalanced to restore the actual sub-index weights to their targeted levels.

On a monthly basis, countries that no longer meet eligibility requirements will be removed and securities within each country will be added and removed at month-end according to GLADI eligibility criteria.

Index Administration and Data

GLADI will be administered and calculated independently from PIMCO by BofA Merrill Lynch Global Research, an unaffiliated leading global index provider. BofA Merrill Lynch Global Research will be responsible for the ongoing application of the index methodology, identification of index constituents and all other technical matters connected to the calculation and provision of index data.

Additional information and access to data can be found at:
www.pimcoindex.com.

GLADI data is available on Bloomberg:



Annualized Returns


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Risk Return






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