Fixed income indexing is a passive investment approach that aims to replicate the performance of a bond index by holding a diversified portfolio of fixed-income securities. Many investors are familiar with indexing in the context of equities, often popularized by figures like Warren Buffett. But how well does this strategy translate to the fixed-income world? Is it just as effective for individual investors?
What is Indexing in Fixed Income Indexing?
Indexing means investing in products that aim to mirror the performance of a specific market index. For fixed-income securities, this means investing in funds composed of a broad range of bonds and structured products that track a particular bond index.
There are many bond indices out there. The most common try to represent the entire universe of fixed-income products on the market, including a mix of federal, provincial and municipal bonds, as well as corporate and foreign debt.
While the concept is similar to stock indexing, there are two key differences when it comes to indexing with fixed income:
The Weighting Problem
When following a stock index, like with a cap-weighted index, such as the S&P500 or the NASDAQ, your investment is proportionally allocated based on the market capitalization of each company. In other words, you’re investing more heavily in companies that the market currently values higher. This logic makes sense.
With fixed income indexing, however, the most significant allocations go to the issuers with the most bonds – or, in some cases, those with the most debt relative to their assets. That means the entities that owe the most money get the largest share of your investment.
While borrowing isn’t necessarily bad, excessive debt can increase the risk of default down the road. Ask yourself: Would you feel comfortable lending money to someone who already owes money to 10 other people? Probably not.
Institutional vs. Individual Needs of Investors
Bond indices were designed with institutional investors in mind – pension funds, insurance companies, and similar entities. These institutions require liquidity and must plan for scheduled cash outflows over multiple time horizons. As a result, their portfolios need to include a wide range of maturities.
But individual investors have different priorities. Your fixed-income strategy should reflect your personal goals and time horizon. For instance, if you’re investing for five years, a portfolio that includes both a 3-month T-bill and a 30-year Canadian government bond – common in indexed bond funds – may not make sense. A more targeted mix, such as a few high-quality municipal bonds, might be a better match for your objectives and provide a better return.
Tailoring Fixed Income Indexing to Your Needs
While indexing can offer diversification – especially for smaller-sized portfolios– it’s not always the most effective way to meet your specific goals.
Individual investors often have well-defined timelines and unique risk profiles. A more tailored fixed-income strategy, built with carefully selected bonds, can help optimize returns and reduce unnecessary risk.
Building the right portfolio takes knowledge and discipline. That’s when the help of an expert can make a meaningful difference.
