Investment grade bond indexes track the performance of bonds rated investment grade by credit rating agencies. They provide a benchmark for measuring returns in the investment grade bond market.
For new investors, learning how bond indexes work can help you better understand this key segment of the fixed income market as you look to build a diversified portfolio.
What are Investment Grade Bonds?
Investment grade bonds are corporate and government bonds that credit rating agencies judge to have a relatively low risk of default.
The top credit rating agencies – Standard & Poor’s, Moody’s, and Fitch – use similar rating scales to assess creditworthiness.
Bonds rated BBB – or higher by Standard & Poor’s and Fitch or Baa3 or higher by Moody’s are considered investment grade.
Investment grade bonds have historically had very low default rates compared to high-yield “junk” bonds rated below investment grade. Their higher credit quality allows them to offer lower yields than non-investment grade bonds.
Major institutional investors like pension funds and insurance companies often limit their bond investments to only investment grade issues. Individual investors may also favor investment grade bonds for lower risk portfolios.
READ ALSO: Are Municipal Bonds a Good Investment in 2024? Pros, Cons and Strategies
What is a Bond Index?
A bond index tracks the performance of a specific segment of the bond market. It provides a representative benchmark for measuring returns.
Well-known examples include the Bloomberg Barclays U.S. Aggregate Bond Index, which covers dollar-denominated investment grade bonds traded in the U.S., and the Bloomberg Barclays Global Aggregate Bond Index, which includes investment grade bonds from around the world.
Bond indexes have a defined set of rules determining which bonds are included. For example, criteria may include:
- Credit rating
- Country of issuance
- Currency denomination
- Minimum time to maturity
- Minimum issue size
The index seeks to capture a broad, diverse representation of the market segment being tracked.
Bond indexes report total returns, combining price changes in the bonds along with interest income received. Investors can use index performance to evaluate how their portfolio stacks up against the broader bond market.
Major Investment Grade Bond Indexes
Several leading providers offer benchmark indexes covering the investment grade bond market. Here are some of the most widely followed:
Bloomberg Barclays Indexes
Bloomberg Barclays indexes cover multiple bond market segments. Their investment grade indexes include:
- U.S. Aggregate Bond Index – The flagship benchmark covering dollar-denominated investment grade U.S. treasuries, government-related bonds, corporates, mortgage-backed securities, and asset-backed securities.
- Global Aggregate Bond Index – Includes Treasury, government-related, corporate and securitized investment grade bonds issued globally in multiple currencies.
- Global Aggregate Corporate Bond Index – Tracks only corporate investment grade bonds traded globally.
ICE Bond Indexes
ICE Data Indices maintains fixed income benchmarks, including:
- ICE BofA US Corporate Index – Measures performance of USD-denominated investment grade corporate bonds issued in the U.S. domestic market.
- ICE BofA US High Yield Index – Tracks below investment grade USD corporate bonds issued in the U.S. domestic market.
- ICE BofA Global Broad Market Index – Represents global investment grade debt from Treasury, government-related, corporate, and securitized fixed-rate bonds from developed and emerging market issuers.
FTSE Russell Indexes
FTSE Russell provides the Bloomberg Barclays indexes under license as well as its own indexes, such as:
- The FTSE World Government Bond Index (WGBI) – Tracks investment grade sovereign debt across multiple currencies from over 20 countries.
- The FTSE World Broad Investment Grade Bond Index (WorldBIG®) – Covers government, government-related and corporate bonds rated investment grade by issuers globally.
Top 5 Investment Grade Bond Indexes
Based on assets benchmarked against them, below are five leading investment grade bond indexes:
1. Bloomberg Barclays U.S. Aggregate Bond Index
The Bloomberg Barclays U.S. Aggregate Bond Index is the most widely used benchmark for the U.S. investment grade bond market. It includes Treasury, government-related, corporate, mortgage-backed and asset-backed securities.
With over $2 trillion in assets benchmarked against it, the index provides a broad representation of U.S. investment grade bonds. It sets the standard for measuring performance in the domestic bond market.
2. Bloomberg Barclays Global Aggregate Bond Index
The Bloomberg Barclays Global Aggregate Bond Index tracks government, government-related, corporate, and securitized investment grade bonds issued globally in multiple currencies.
With wide coverage of the global bond market, it serves as a benchmark for international bond fund performance and provides diversification beyond just U.S. bonds.
3. ICE BofA US Corporate Index
The ICE BofA US Corporate Index narrowly focuses on measuring the investment grade U.S. corporate bond market. It includes publicly issued U.S. corporate debt graded BBB3 through AAA.
The index allows investors to isolate corporate bond performance from other fixed income sectors. It provides a benchmark for investment grade corporate bond funds.
4. Bloomberg Barclays Global Aggregate Corporate Index
This index tracks investment grade corporate bond performance across global markets. It covers industrial, financial institution, and utility fixed-rate debentures in multiple currencies.
The global scope offers a benchmark for understanding trends in worldwide corporate debt markets beyond just U.S. corporates.
5. FTSE World Government Bond Index
The FTSE World Government Bond Index measures the performance of investment grade sovereign debt from over 20 countries. It covers government bonds denominated in a variety of currencies.
This index provides a benchmark for understanding debt issued by governments in developed countries. It can serve as a baseline for fixed income investors with significant allocations to global government bonds.
Constructing a Bond Index
Bond indexes rely on transparent, rules-based methodologies to select and weight components in order to track a defined market segment. Here is an overview of key steps in constructing an index:
1. Establish inclusion criteria
The index provider establishes standards that each security must meet to be included in the index. Common criteria include:
- Credit rating – Typically an investment grade for broad-based indexes.
- Country of issuance – Global, regional, or single country focus.
- Currency denomination – Such as restricting to USD-denominated bonds.
- Minimum time to maturity – For example, at least 1 year.
- Minimum issue size – Such as $500 million minimum outstanding.
2. Screen the market
The entire universe of bonds is screened to identify those that meet all the predefined inclusion requirements. This establishes an investable market that matches the index’s focus.
3. Apply weighting methodology
An index weighting methodology determines each bond’s influence on index performance. Market capitalization weighting based on the amount outstanding is common. There are also alternative weighting schemes, such as equal weighting.
4. Update on periodic schedule
The index has rules determining when updates to its constituents are made, such as on a monthly, quarterly, or annual basis. Evolving market conditions will cause new bonds to become eligible while existing ones fall out. Rebalancing keeps the index current.
5. Calculate price return
The index calculates the price return using the regular market prices of its constituent bonds. Trading activity determines fair value pricing.
6. Reinvest income
Interest income from the bonds is assumed to be reinvested back into the index at periodic intervals. This allows the index to reflect the total return from both price changes and income.
7. Disseminate index values
Updated index values reflecting the aggregated performance of its underlying bonds are calculated and published at regular intervals (such as daily).
REA ALSO: What is a Bond ETF and is it a Good Investment?
How Bond Indexes Are Used
Bond indexes serve several key functions, including:
Performance measurement
A bond index provides a benchmark to measure performance against. Investors can evaluate the returns of an actively managed fund versus its index to assess the results.
Indexed investing
Bond index funds aim to replicate index performance by holding a portfolio of securities matching the index. Indexing provides low-cost, diversified bond exposure.
Asset allocation decisions
Index returns help investors evaluate opportunities across bond segments and markets. Allocation can shift towards areas of the market that show promising index performance.
Portfolio hedging
Derivatives based on bond indexes, such as futures contracts, allow investors to hedge portfolio risks or gain exposure without owning the underlying bonds.
Research and analysis
By summarizing broad sections of the bond market, indexes provide key information for conducting research and analysis on the fixed income asset class.
Investing in Bond Indexes for Beginners
While understanding index construction is useful background, most individuals invest in bond indexes via passively-managed mutual funds and ETFs. This grants easy diversified exposure mirroring benchmarks like the Bloomberg Barclays Aggregate Bond Index.
Consider these steps for beginners:
1. Determine Your Fixed Income Allocation
Decide on the right bonds allocation percentage based on your risk tolerance, time horizon, and income needs. A financial advisor can help with this asset allocation calculation if you are unsure.
2. Select Your Preferred Investment Grade Index
Choose an index fitting your investment objectives, such as broader aggregate indexes or specific sector ones like governments. Common indexes were highlighted earlier.
3. Find Index Funds Tracking Your Index
Leading fund managers offer mutual funds and ETFs closely replicating the best-known bond indexes. Screen for index funds with:
- Low expense ratios
- Tight tracking error
- Adequate liquidity
4. Build and Rebalance Your Portfolio
Invest in bond index funds per your strategic asset allocation. Revisit weightings periodically and rebalance back to targets. Enjoy diversification across hundreds of investment grade issues.
Leveraging Investment Grade Bond Indexes
While sticking fully to mainstream aggregate indexes works for most goals, some investors utilize specialty investment grade benchmarks for specific portfolio objectives:
Compare Active Managers
Evaluate active bond fund manager alpha by comparing returns to index returns over relevant time periods. Indexes provide the zero-fee baseline for outperformance.
Tilt Toward Preferred Sectors
Tilt fixed income exposure toward attractive sectors based on yield spreads or other metrics. For example, allocate more to corporations when yield spreads are high via corporate bond indexes.
Hedge Interest Rate Risks
Hedge against rate shifts using indexes with different duration exposures. Adding long-term bond index funds provides a hedge if rates fall, for instance.
So indexes shouldn’t just serve as passive investments. Savvy investors can utilize them more actively to optimize fixed income portfolios.
Key Questions about Investing in Bond Indexes
For new investors evaluating investment grade bond index funds, here are some key questions to ask:
What is the index’s average credit rating?
Ensure the index maintains adequate credit standards that fit your risk tolerance. Most benchmark-style indexes require investment grade ratings.
Does the index cover my desired sectors?
See if the index aligns with your preferred fixed income allocation across governments, corporations, mortgages, municipals, etc.
What is the index’s duration?
Understand the index’s interest rate risk. Shorter duration indexes fluctuate less with rate shifts.
Asking these questions will help determine if an investment grade bond index properly matches your investing preferences as a beginner.
The Bottom Line
Investment grade bond indexes provide critical performance benchmarks for fixed income markets. They inform portfolio decisions for conservative investors favoring higher-quality debt.
Gaining investment exposure via bond index mutual funds and ETFs is recommended for most individual investors over buying individual securities. Top index funds are liquid, diverse, low-fee, and track industry benchmarks closely.
While understanding index construction rules is a helpful background, ultimately, bond index investing for beginners boils down to picking suitable funds that match your risk tolerance and goals. Monitor your performance using the same benchmark gauge.
Over long time periods, adding indexed investment grade bond exposure can anchor portfolios, providing stability to balance equity volatility. Just maintain an asset allocation and risk profile aligned with your needs.
FAQs about Investing in Bond Indexes
What percentage of a portfolio should be in investment grade bond index funds?
Most financial advisors suggest keeping bond allocations between 20-50% of total portfolio assets based on your individual risk tolerance and investment timeline.
Of this fixed income allocation, using low-cost investment grade bond index funds for core exposures up to 75% is reasonable for conservative investors. Actively managed funds or individual bonds can occupy the remainder.
What is the difference between an aggregate bond index and a corporate bond index?
An aggregate index like the Bloomberg Barclays US Aggregate Bond Index contains investment grade bonds across multiple fixed income sectors – including Treasury bonds, mortgage-backed securities, and corporate bonds.
Alternatively, a corporate bond index such as the Bloomberg US Corporate Bond Index only holds investment grade corporate bonds – providing a benchmark for that specific segment of bonds.
What is the best bond index to invest in?
The Bloomberg Barclays US Aggregate Bond Index is one of the most widely followed fixed income indexes. It broadly represents investment grade U.S. bonds across maturities.
As a benchmark for bond performance, adding exposure via aggregate index mutual funds, or ETFs, works for most conservative investors seeking a slice of the broader, high-quality U.S. bond market.
Alternatives like corporate and government bond indexes also provide targeted exposure if you want to focus on specific fixed income sectors.
How often do investment grade bond indexes rebalance?
Bond indexes have set schedules for assessing current constituent bonds to ensure they still pass credit rating and sector diversification rules. This rebalancing and reweighting process keeps the index updated.
Frequent rebalancing also allows new quality bonds to enter the index while downgraded bonds exit. These maintenance processes help the index continue to accurately reflect the investment grade bond market it tracks.
Major bond indexes tend to rebalance monthly or quarterly. Ongoing qualitative analysis may also prompt off-cycle changes if rating agencies downgrade/upgrade specific issues.
What yield can I expect from an investment grade bond index fund?
Yields fluctuate over market cycles, but investment grade bond indexes have generally delivered 2-6% historical yields based on periods measured. The lowest end reflects current yield scenarios amid low interest rates.
For context, as of January 2023:
- Bloomberg Barclays Aggregate Bond Index yield = 3.78%
- Bloomberg US Corporate Bond Index yield = 4.98%
So while not high, investment grade bond index funds offer reasonable income that is also more stable and less risky than non-investment grade bonds targeting higher yields. Compare taxable equivalent muni bond yields as well.
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