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The Role of Fixed Income Benchmarks

May 2007
Lev Dynkin, Managing Director
Global Head of Quantitative Portfolio Strategies
Why use a benchmark?

 Is the portfolio manager adding value vs a naive (“zero skill”) investment

strategy given the opportunity set and constraints?

 What is the long term risk appetite?

 Long-term strategic asset allocation

 Most asset management mandates come with a specified benchmark and

constraints on deviation from it

 Most mutual funds have a stated benchmark to let buyers know the nature of
major allocations

 Reasons for benchmark customization:

− Liability-based benchmarks
− Reflect constraints

Common and Distinct Features of Bond Indices

 Bond indices are market weighted average returns of individual securities

 Most fixed income securities trade OTC and are priced by the index provider
or a third party service

 Lehman bond indices have index statistics (risk sensitivities to yield curve
and spread changes, avg. yield, avg. coupon) in addition to returns

 Standard Lehman bond indices include securities that meet pre-specified rules

 Customized indices may follow a different set of rules for inclusion of


 Indices may be produced for strategies (long corporate bonds, short duration-
matched Treasury bonds) or derivatives (swap indices)

Customized Indices

 Lehman publishes daily on its website about 2,000 standard indices covering
a broad range of asset classes in 30 currencies and over 5,000 customized
indices for specific investors

 Customized indices reflect constraints of specific investors

− Constraints on realized gains or losses  book yield indices

− Liability-matching constraints

− Changes to index inclusion criteria (e.g. only bonds rated A and above)

− Target specific asset class weights (e.g. 50% govt, 50% corporates)

− Issuer caps (e.g. no more that 2% of portfolio in any issuer)

Main Dilemma of Indices

Investable vs representative indices:

− baskets of securities
− broad-based reflection of the opportunity set

Under-sampling vs over-sampling

Pricing a broad universe of securities

Systematic risk vs idiosyncratic risk

Lehman’s Bond Market Indices are broad-based representations of the

investment opportunity set

What defines a good benchmark?

A good benchmark should include the following properties]

− Universe is well defined, with transparent rules
− Securities are investable; benchmark is replicable
− Daily performance data is available
− Current characteristics are available (e.g., price, coupon, duration, etc.)
− Historical information is available
− Investment style is clearly defined
− Risk profile is well defined
− Benchmark is specified in advance
− Turnover is low

The Lehman Global Family of Indices meets these criteria.

− All indices are rules-based, meaning that inclusion in a Lehman Brothers index depends on
satisfying clearly pre-specified criteria.
− Comprehensive statistics about each index are readily available to investors, and
performance results are available daily for most indices.


Assets under Management
Benchmarked vs. Major Lehman Brothers Indices
December 2006 Total: $6.11trn

Lehman Brothers Index AUM (Estimated)

U.S. Aggregate $2.40trn
U.S. Universal $194bn
Global Aggregate $1.10trn
U.S. Government / Credit $613bn
Pan-Euro Aggregate $105bn
Euro Aggregate $483bn
U.S. High-Yield $82bn
Custom / Other $1.10trn

Lehman Brothers Global Family of Indices: May 2007
96 Indices; 7 Flagship Indices
Global Aggregate, U.S. Aggregate, U.S. Universal, Pan-European Aggregate,
Euro-Aggregate, Asian-Pacific Aggregate, Multiverse


U.S. Floating-Rate
Other Debt and Swaps Indices Universal
Global Aggregate Global High-Yield Global Asset Class Indices Indices
Dollar, Euro,
Sterling, & Yen U.S. Municipals U.S. Pan-European Global Global Global Global JGB
Asian-Pacific Other Global Agg Inflation- Global Emerging FRN
Swap Indices Aggregate Components Treasury Credit
Aggregate Aggregate Linked Securitized Markets
Global Capital Swiss Franc U.S.
Securities Aggregate Non-U.S. Euro Sterling Non- Japan Non- Canadian Global Inv-
Aggregate Aggregate Aggregate EMU Agg Japan Aggregate Grade Corp

High-Yield Issuer Mexican

Government Bond ZAR, CHP,
Pan Euro Pan Euro
Capped / VLIs MXN UK Gilt Majors ABS FRN
Index U.S. HY U.S. Euro Swedish Asia-Pacific HY 144-A’s CMBS EUR
Treasury Gilt Aggregate Treasury
Corp Treasury Treasury
U.S. Convertibles U.S. Corp.
CMBS High-Yield Investment Eurodolla
Index CMBS HY Eurozone Others FRN
Euro U.S. Gov- Euro Gov- Danish Asia-Pacific -Grade EM r ABS GBP
dollar Related Related Non-Gilt
Zero-Coupon Aggregate Gov-Related
Short Pan Euro Corp
Nominal & Inflation Euroyen Global
U.S. Gov/Credit U.S. Euro EM HY JGB Covered FRN
Swaps Indices 144A Norwegian Asia-Pacific HY Corp
Corporate Corporate
Aggregate Corporate
U.S., Euro, Yen
Chinese Aggregate U.S. HY
CDS/ CDX iTraxx Non- Eastern Eurodollar Canada
Index U.S. Euro Asia-Pacific Ex Agg FRN
TR ERISA Securitized Europe
Securitized Securitized
CMBS Treasury
Indian Government CMBS IO 144A Ex U.S. HY
Danish Agg Loan
MBS (Japan Agg Only)

Emerged ERISA
CMBS Non-Debt Indices
Commodity Index Global Hedge Fund
FX Indices
(LBCI) Indices
Fixed Rate

Hybrid ARM
(U.S. Agg Only)

Index Rules & Construction
Basic Principles of Lehman Indices


 Monthly Reset

 Market Value Weighted

 Total Return Calculations

Monthly Index Dynamics: Building a Rules-Based Index

Returns Universe Statistics Universe

 Static universe set at  Dynamic universe
beginning of month Returns changes daily
– Avoids “hitting a Universe – Used for rebalancing
moving target” Backward purposes
 Includes bonds that  Includes bonds that during
during the month the month have been –
have been – – Newly issued
– Called – Upgraded to investment
– Downgraded below Forward grade
investment grade  Used to forecast next
– Sunk below $250MM Statistics month’s returns universe
 Used to report index
performance (returns)

Global Aggregate Index: Factsheet / Rules
Index Overview

The Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets.
The Global Aggregate Index contains three major components: the U.S. Aggregate Index (USD 300 million), the Pan-
European Aggregate Index (EUR 300 million), and the Asian-Pacific Aggregate Index (JPY 35 billion). In addition to
securities from these three benchmarks (94.4% of the overall Global Aggregate market value), the Global Aggregate
Index includes Global Treasury, Eurodollar (USD 300 million), Euro-Yen (JPY 35 billion), Canadian (CAD 300
million), and Investment-Grade 144A (USD 300 million) index-eligible securities not already in the three regional
aggregate indices. The Global Aggregate Index family includes a wide range of standard and customized subindices by
liquidity constraint, sector, quality, and maturity.

Sector Breakdown as of 12/31/2006 Quality Breakdown as of 12/31/2006 Access to the Index

A 5.2%
Securitized 11.1% LehmanLive Website
• Daily index returns and statistics
Treasury • Historical time series downloadable into Excel
Corporate 48.7%
• Standardized market structure reports
Aa 55.5% • Fully customizable views
28.2% • Index primers and shelf reference documents
Government- • Latest index and portfolio strategies research
Related publications

Global Aggregate Index: Factsheet / Rules
Rules for Inclusion
Amount Outstanding The minimum liquidity criterion is based on eligible currencies, as follows:
 For U.S. Aggregate, Canadian, Eurodollar, and Investment-Grade 144A Index securities, USD 300 million (or
equivalent) minimum par amount outstanding. CMBS and ABS securities must belong to a deal with a minimum
aggregate transaction size of USD 500 million.
 For Pan-European Aggregate Index securities, EUR 300 million currency equivalent minimum par amount.
 For Asian-Pacific Aggregate and Euro-Yen Index securities, JPY 35 billion minimum par amount outstanding.
 For GBP denominated securities, GBP 200 million currency equivalent minimum par amount outstanding.
 For securities in other eligible currencies, minimum amount outstanding is pegged to one of the four major
currencies above, using an exchange rate that is reset once a year on the last business day of November.
WM/Reuters exchange rates are used.
Quality Must be rated investment grade (Baa3/BBB-/BBB- or above) using the middle rating of Moody’s, S&P, and Fitch,
 When all three agencies rate an issue, a median or “two out of three” rating is used to determine index eligibility
by dropping the highest and lowest rating.
 When a rating from only two agencies is available, the lower (“most conservative”) of the two is used.
 When a rating from only one agency is available, that rating is used to determine index eligibility.
 Unrated securities are included provided that an issuer rating is applicable.
 Domestic local currency sovereign debt will be use the most observed bond level rating for all outstanding bonds.
Maturity  At least 1-year until final maturity, regardless of optionality. For securities with coupon that converts from fixed
to floating rate, at least 1-year until the conversion date.
 MBS must have a weighted average life of at least 1-year; ABS must have a remaining average life of at least 1
year; CMBS must have an expected maturity of at least 1-year.
 Perpetual securities are included in the index provided they are callable or their coupons switch from fixed to
variable rate. These are included until one year before their first call date, providing they meet all other index
Currency Currencies eligible for inclusion must be freely tradable and hedgeable; local currencies’ sovereign bonds (both
local and foreign) must have an investment-grade sovereign rating using the middle rating. The list of eligible
currencies is reviewed once a year. Thai baht debt was removed from the index on March 1, 2007.
 U.S. and Canadian Aggregate Index securities: USD, CAD.
 Pan-European Aggregate Index securities: EUR, GBP, CZK, DKK, HUF, NOK, PLN, SKK, SEK.
 Asian-Pacific Aggregate Index securities: JPY, AUD, HKD, KRW, NZD, SGD, TWD, MYR.
 Additional eligible currencies: CLP, MXN, ZAR.

Global Aggregate Index: Factsheet / Rules
Pricing & Related Issues
Sources & Unless noted otherwise, index bonds are priced by Lehman Brothers traders at mid-month and month-end. On a daily basis, a subset of
Frequency the index continues to be trader priced, with the remaining bonds model/ matrix priced using actively traded benchmark securities to
generate issuer pricing curves and populate a spread matrix algorithm or sourced from third parties.
U.S. Aggregate Index, Eurodollar Index, 144A Index: Treasuries are trader priced daily; up to 1,000 benchmark Corporates are
trader priced daily; some Agency debentures are trader priced daily; MBS bonds are priced by traders on a daily basis, with generic
prices derived from these marks; ABS spreads are marked weekly to generate daily prices using changes in the Treasury and swap
curves; CMBS spreads are marked daily.
Pan-European Aggregate Index: Lehman Brothers traders price more than 75% of the market value of the index; the remainder is
priced by third party sources or by a spread matrix algorithm. Traditional Pfandbriefe are curve-based, Jumbo Pfandbriefe and Danish
MBS are vendor priced.
Asian-Pacific Aggregate Index, Euro-Yen Index, and Other Currencies: Daily prices provided by outside sources if trader marks
are unavailable.
Canadian Index: Daily pricing is provided by Scotia Capital.

Pricing Quotes Bonds can be quoted in a variety of ways including nominal spreads over benchmark securities/treasuries, spreads over swap curves, or
direct price quotes as a percentage of par. In most instances the quote type used is a spread measure that results in daily security price
changes from the movement of the underlying curve (swap or treasury) and/or changes in the quoted spread.
Bid or Offer Bonds in the index are priced on the bid side. The initial price for new corporate issues entering the index is the offer side; after that,
Side the bid side price is used.
Frequency The composition of the Returns Universe is rebalanced monthly, at each month end and represents the set of bonds that returns are
calculated on. The Statistics Universe changes daily to reflect issues dropping out and entering the index, but is not used for return
calculation. On the last business day of the month, the composition of the latest Statistics Universe becomes the Returns Universe for
the following month.
Index Changes During the month, indicative changes to securities (maturity, credit rating change, sector reclassification, amount outstanding) are
reflected in both the statistics and returns universe of the index on a daily basis.
Reinvestment of Interest and principal payments earned by the returns universe are held in the index without a reinvestment return until month-end
Cash flows when it is removed from the index.
New Issues Qualifying securities issued, but not necessarily settled, on or before the month-end rebalancing date qualify for inclusion in the
following month’s returns universe.

Global Aggregate Index Returns (Hedged and Unhedged in ILS)

Monthly Global Aggregate Index Returns Since 2001 (in Israeli Shekel)































Unhedged Hedged

Cumulative Return (%)















Hedged Jul-04







Cumulative Global Aggregate Index Returns Since 2001 (in Israeli Shekel)



Global Aggregate Index Returns (Hedged and Unhedged in ILS)

Non-traditional benchmarks

 Traditional indices represent the investment opportunity set in proportions to

market capitalization

 Benchmark may represent a “no view” investment portfolio

 Any investment process can be benchmarked:

Corporation Z generates its revenue in US$ and Euro, but reports earnings
in US$. The Treasurer can hedge expected Euro revenue into US$ 1 year
out and take the risk of revenue fluctuation or hedge monthly and take
the currency risk. How should the Treasurer be evaluated at the end of
the year?

Managing a Portfolio
Relative to a Benchmark
Basic Steps in Quantitative Portfolio
Management vs. an Index
 Standard and custom indices
 Justification of asset class selection in the benchmark
 Setting a benchmark duration target
 Justification of investment style
 Profiling of the portfolio vs. benchmark to examine intentional and
unintentional exposures (Market Structure)
 Measuring portfolio risk relative to benchmark (Risk Model)
 Comparing projected scenario returns (Scenario Analysis)
 Attribution of achieved return advantage to manager decisions
(Performance Attribution)

“Market structure” example:
Profiling the portfolio relative to the Benchmark

80/20 Composite vs. Govt/Corp Index

Govt Corp Total
Portfolio (%) 80.00% 20.00% 100.00%
Benchmark (%) 69.66% 30.34% 100.00%
Difference (%) 10.34% –10.34% 0.00%
Portfolio Dur. 5.41 6.08 5.54
Bmk. Dur. 5.41 6.08 5.61
Difference 0.00 0.00 –0.07
Portfolio Cnt. Dur. 4.33 1.22 5.54
Bmk. Cnt. Dur. 3.77 1.84 5.61
Difference 0.56 –0.62 –0.07
Scenario Analysis

80/20 Composite vs. Govt/Corp Index

Scenario Position Benchmark Difference
(1-month horizon) Return % Return % %
Up 50 bps –2.25 –2.28 0.03
2–30s Steepen 20 bps 0.42 0.43 –0.01
No Change 0.41 0.42 –0.01
2–30s Flatten 20 bps 0.40 0.41 –0.01
Down 50 bps 3.23 3.28 –0.05
Spreads widen 20% 0.13 0.02 0.11
Why do we need a Risk Model?
Quantify the market risk embedded in a portfolio
 In absolute terms: expected volatility of the portfolio total returns
 In relative terms: tracking error volatility
Attributes ex-ante risk to major decisions implemented by fund
 Currency allocation
 Interest rate management: duration and yield curve exposure
 Swap spreads
 Interest rate volatility
 Credit allocation
 Name and security selection
Can be used in
 Monitoring active risk
 Portfolio optimization
 Risk budgeting
 Scenario analysis

Example Risk Model Report
What are the sources of risk?
 Tracking error volatility
(TEV) is the primary
measure of portfolio risk
vs. the benchmark
 TEV is the projected
standard deviation of the
return difference between
the portfolio and the
 It is calculated based on
differences between
portfolio and benchmark
exposures to risk factors
from several categories

Example Risk Report: Factor Exposures
What is the portfolio’s sensitivity to risk factors?
 For each market risk factor, there is a
contribution to tracking error:
TE impact of risk factor =
Net exposure x Factor volatility

 The overall TEV of the portfolio

considers correlations among factors as
well as their volatilities

 Modeling can be very specific: for

example, yield curve exposures are
modeled by key rate durations along the
curve, not just a single duration

Performance Attribution

 Explain portfolio outperformance relative to the benchmark in terms of

manager decisions:
– Positioning along the yield curve (duration, etc.)
– Sector allocation
– Security selection
 Answers two types of questions:
– Assume portfolio earns benchmark returns in each risk sub-category.
What outperformance results from weight differences alone?
– Portfolio return differs from benchmark return within the most
narrowly defined cell. What outperformance results from this
difference in security selection?

Basics of Performance Attribution
RB = ∑ wiB ri B

RP = ∑ w r P P
i i

RP − RB = ∑ w r − w r + w r − w r
i i
i i
i i
i i )

= ∑ w ri − ri
) + ∑ (w i
− w ri
) B

i i

= ∑ w (r i
− ri B
) + ∑(w i
−w i
) (r
− RB )
i i
sector i overweight × sector i outperf vs. index
Security selection Allocation
Index Replication

 A portfolio of 50 corporate bonds can replicate a corporate index of 3,000+

securities with a TEV (Tracking Error Volatility) of 15 bp/month

 A portfolio of 12-14 TBA securities can replicate the MBS index of 360+
securities with a tracking error of 4 bp/month

 RBISM (Replicating Bond Index) baskets of liquid derivatives (Treasury

futures, interest rate swaps, CDX/iTraxx & FX forwards)
can replicate the Global Aggregate Index of 11,000+ securities with a TEV of
5 bp/month

RBI is a service mark of Lehman Brothers, patent pending


 Benchmarks provide an objective way to measure portfolio performance

 Benchmarks can be customized to fit almost any mandate
 Benchmark selection shifts the strategic asset allocation decision from the
portfolio manager to the plan sponsor
 Benchmarking changes the framework for measuring risk:
– Active risk instead of absolute risk
– Measured by tracking error volatility (TEV)
– Keep track of net exposures vs. the benchmark
 Index replication techniques can help build “portable alpha” strategies
designed to outperform a desired benchmark

Analyst CertificationThe views expressed in this report accurately reflect the personal views of Lev Dynkin, the primary analysts responsible for this report, about the
subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations
or views expressed herein.

Important DisclosuresLehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market
maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have
either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers.Where
permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to
determine current prices of fixed income securities.The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited
to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the
Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research
with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies
discussed in its research reports. As a result, investors should be aware that the firm may have a conflict of interest.To the extent that any historical pricing information
was obtained from Lehman Brothers' trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do
not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document.Lehman Brothers' global policy for
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