An insight into the issue of fixed income benchmarks and the liquidity of some of the underlying constituents comes from Richard Darby-Dowman, a senior investment manager with State Street’s fixed income team.

Darby-Dowman, who has responsibility for the SPDR Bloomberg Barclays Euro Aggregate Bond UCITS ETF, points out that one of the most common questions he faces is how much of the fund can be traded per day.

“Clearly, market conditions play a role, but trade sizes are usually below €1m, which is typically a fraction of the amount traded in the market under ‘normal’ market conditions,” he says.

When it comes to the issue of liquidity, to an extent Darby-Dowman says the job is effectively outsourced to the index provider. As such, index inclusion criteria are important.

“The inclusion criteria of a well-constructed index are typically designed to exclude illiquid securities,” he says. “This can be achieved by including a minimum issuance size or excluding specific bond types, for example.”

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When it comes to inclusion criteria of the Bloomberg Barclays Euro Aggregate index, they are designed to provide diversification via a large number of constituents, and Darby-Dowman says this helps to mitigate liquidity issues caused by large trade orders. However, he adds that no index provider can guarantee that less liquid bonds will not become constituents of their indices.

“A well-constructed inclusion criterion provides an initial barrier to entry but the portfolio management technique of stratified sampling can also be used, particularly for credit exposures,” he adds.

In this way, portfolio managers can avoid purchasing less liquid securities by trading securities with similar characteristics and contribution to risk.

But Darby-Dowman adds that regardless, less liquid securities do not necessarily mean they are harder to execute or will incur greater trading costs.

“Faced with such a scenario, orders are unlikely to be shown to multiple counterparts, especially when trading in large size in illiquid markets,” he says.

In State Street’s case, where necessary the most appropriate dealer is determined through market insight from the trading desks. Traders will then work orders for illiquid securities and for large positions but control the process to understand market impact rather than leave a broker with discretion over the order.

Narrowing down the scope

The Bloomberg Barclays Euro Aggregate index has nearly 5,200 bonds within it and the fund follows the index as closely as possible. However, stratified sampling is used due to the large number of securities in the index, some of which can be expensive, illiquid or even unable to be purchased in the quantities needed.

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This explains why the SPDR Bloomberg Barclays Euro Aggregate Bond UCITS ETF actually contains at present only 1,898 bonds. By dividing the index into “manageable risk buckets”, such as currency, yield curve, duration, sector, credit rating, issuer and liquidity, the portfolio is built and managed within tolerances to these parameters, says Darby-Dowman.

“A benefit of being an aggregate fund is that risk can be managed at the top level, which would be very difficult if holding a separate fund for each sector,” he says. “For example, some legacy government-related securities can be expensive to source, but by taking a small overweight in treasury bonds we can keen the country exposure neutral.”

In terms of the current market backdrop where a number of European government bonds are ‘delivering’ negative yields, Darby-Dowman says the positive yield to maturity currently being produced by the fund, along with its duration of 7.1 years, makes it an attractive investment proposition.

He adds that the diversification on display within the fund is also evident in the correlation of the Euro Aggregate index returns versus the various components of the index and other treasury markets. “This diversification has led to relatively attractive historical risk-adjusted returns compared to broad European government indices,” says Darby-Dowman.