Bond Index Funds

How do bond index funds work? They’re not as easy as stock index funds. Stock index funds own shares of each stock in the index in the ratios found in the index. How do you do that with bonds? Especially when all bonds of a given issue may be held? Read on to find out.

Disclaimer

No investment recommendations be here. Just my understanding of how bond index funds (either mutual funds or exchanged traded work). Exchange Traded Funds add a layer of complexity in that “creation units” are behind the curtain. ETF workings are beyond the scope of this article.

References

  1. https://en.wikipedia.org/wiki/Bond_market_index

What is a Market Index

A market index reduces a basket of investment instruments to a figure of merit that is

  • Easily calculated
  • Is in some way representative of the content of the basket

A stock market index is typically calculated from the asset value by combining the current asset prices of the instruments in the index in some way. The index may be price based or market capitalization based (price times shares issued).

The nice thing about an index is that it is abstract. You just calculate it. You don’t have to, you know, actually own the stuff in the index.

In the case of an S&P 500 index fund, the fund can actually own shares of each of the 500 stocks included in the index. But how can a “total market” bond fund do that?

How an Index Fund and an Index Differ

An index fund differs from an index in that the fund actually owns  instruments mix in the amounts to match the index. A bond index fund like like Vanguard VBLTX Total Bond Market Fund Index actually owns bonds.

Companies issue bonds in much smaller numbers than stock shares. It is entirely possible that a popular bond having low risk, high yield, and a short maturity might be in an index but no shares are available to be held in a bond fund. Given this reality, bond funds must work differently than stock funds.

Bond Funds Replicate the Index Statistics

Bond index funds “sample the market” by buying a basket of bonds that replicate the yield, time to live, and probability of maturing of the bonds in the chosen index.

It is not sufficient to reproduce the average, for example, the average yield, as many different distributions of yields have the same average. Rather the manager samples to reproduce the yield distribution. If you divide the range of yields in the index into say 3 bins, some number of yields will be in bin 1, some in bin 2, and some in bin 3. Say 1/4 may be in bin 1, 1/2 in bin 2, and 1/4 in bin 3. In practice, many more bins are used.

The index fund manager does this with yield, time to live, and probability of maturing (1 – probability of default).  Bond rating is used as a proxy for probability of maturing.

Their may be more factors considered but these 3 are essential.

How do bond index and bond funds differ?

Bond funds and bond index funds follow similar selection strategies. They try to hold funds that match the objective holdings statical model. The primary difference is that an index fund buys the bond and holds it until it expires either by maturing or by default. It then replaces the expired bond with a similar one.

An actively managed bond fund is free to buy and sell the bonds at the whim of the manager. If the manager sees a better deal, the manager is free to replace a bond in the portfolio with the shinier one that just became available or was recognized as shinier. So the bond index fund does minimal training to maintain the basket while the bond fund is free to cull and replace newly unattractive bonds with more attractive bonds.

Growing and Shrinking

How do funds respond to purchases and redemptions? As shares are sold, new money comes into the fund. When shares are sold, money leaves the fund. All funds hold some cash so they can respond to the day’s sales without selling bonds. But the herd can come and it can go at a whim.

Growth is easy. The fund doesn’t strive to exactly match the target statistics. Each figure of merit has a target range. As redemptions require sales, the manager sells the least attractive bonds in the portfolio as indicated by below median yield or above median risk of default. As purchases are required, the manager adds bonds to the holdings to maintain the yield distribution, reduce risk of default, and maintain time to live distribution.

What is time to live?

I’m using time to live as a synonym for time to maturity. I wanted to be clear that I was talking about the term remaining rather than the term at issue as in 10 year Treasuries.