Credit Risk: From Transaction to Portfolio Management

A good index system

There is currently a bewildering choice of potential benchmarks proffered

by a large number of vendors. It is incumbent upon us to introduce

some criteria for benchmark selection particularly within the realms of

European credit, which in contrast to the US, has not quite evolved

towards an industry standard.

It is a common misconception among bond investors that any rule-

based index will display consistency of risk-return profiles for related

holding periods. This is certainly not the case and while volatility levels

will be in some accordance, the levels of return can be appreciably

different. The source of this discrepancy is usually the introduction of

proxy pricing for illiquid bonds incorporated as index constituents.

This may seem attractive until the considerations of actually trading

these bonds are entertained. By way of conclusion the portfolio man-

ager should perform diligence on an index and ensure it is a liquid

rule-based aggregate that is representative of the market.

There exist a large number of classical prescriptions as to what con-

stitutes a good benchmark. However it must be borne in mind, particu-

larly with regard to credit investing, of equal import to the quality of

design is the quality of the data. Together with the infrastructure sup-

porting the provision of the service.

Many vendors regard the provision of an index service as highly

proprietary, consequently constituent data and methodology are only

available on a commercial basis. Further a custom index creation

facility, allowing the user to tailor the benchmark according to their

risk/return appetites, may be sold as a differentiating capability. These

developments have been a hindrance to market progression in general.

Given the dramatic decrease in the cost of mediating information it is

now becoming viable to compete only on bespoke index services rather

74 Credit risk: from transaction to portfolio management

iBoxx pricing (real-time and historical)

iBoxx index family (real-time and historical)

Shared,

public

domain

OTC derivatives

Exchange future

Portfolio services

Portfolio attribution

return attribution etc.

Optimizations

Electronic

trading

Deutsche

bank

vs.

Competitors

Web system:

index.db.com

Figure 1.41 The current and future of credit index. Source: Deustche Bank.