Like other capital markets, municipal debt markets are made up of a wide array of debt instruments and serve investors from all walks of life. Whether you are a conservative investor looking for principal protection while earning enough to keep up with inflation or a moderate risk taker who might be looking for high returns on your municipal debt portfolio, you’ll find many debt instruments to fit your profile.
Similarly, these various debt issues are unique in their own way with differing characteristics like the risk profiles associated with their credit quality and the duration of their potential returns. To help investors compare and evaluate their potential investments, these characteristics are summed up into benchmarks and market indices.
These benchmarks are quite helpful for issuers and investors in evaluating a debt instrument’s yield and comparing that to a particular sector or the municipal debt markets as a whole.
In this article, we will take a closer look at a bond index, its composition, its uses and how it can provide a competitive edge to an informed investor.
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Understanding an Index
Before we get into a bond index and its uses, let’s look at a simple index that most investors are familiar with – the S&P 500 Index. The S&P 500 Index is one of the most common benchmarks for the broader U.S. equity markets; as the name suggests, this index tracks the market capitalization of 500 large publicly traded companies. Thus, when an equity investor is looking to evaluate a particular stock and compare that to the equity markets, he or she can easily compare the performance of an individual stock to the performance of the S&P 500 Index to gauge the comparative success of his or her investment.
A bond index is comprised of similar debt instruments to measure changes in yield or performance. As mentioned above, indices are created by grouping securities with similar characteristics together and tracking their performance as a whole; in a bond index, these characteristics may include credit ratings, maturities, issue size, issuer profile, sector or geographic location. After grouping similar securities, an index is created by either calculating the simple average of the underlying securities’ prices or yields, or some other method that can track the overall performance of the group of instruments as a whole.
With an index established, an investor who is looking to evaluate a municipal debt instrument with similar characteristics can easily compare the returns and overall performance to the index. It can provide him or her an average snapshot of similar securities in the market.
Uses of Bond Indices
As mentioned, bond indices can be very helpful in evaluating bond yields and prices for investors and their issuers. The average snapshot and potential outlook on the municipal debt markets can help issuers in their bond pricing.
For example, Prince William County of Virginia, an AAA-rated entity, is likely to use a bond index similar to their institution profile to gauge the municipal debt market and price their issuance accordingly. Some of the key purposes of a bond index are:
- Bond indices are used to establish the appropriate yield of municipal securities for issuance and investments.
- Since bond indices provide a relative snapshot of the market, they can be used to follow broad trends in the municipal debt markets and examine the overall market performance over time.
- In addition, bond indices may serve as a baseline for evaluating the performance of a set of bonds with similar characteristics like credit profiles or maturities.
In addition, bond indices play an integral part in the creation of bond portfolios or mutual funds and serve as a critical benchmark to evaluate the performance of a bond portfolio. Many portfolio managers or fund managers compare their returns against benchmark returns and use the comparison as a selling point for their fund.
Frequently Used Benchmarks in the Municipal Debt Markets
In the U.S. municipal markets, there are many financial institutions that have created their own benchmarks for investors and issuers to use in issuances or other evaluation purposes. Here are some of the most commonly used indices and their compositions:
- Bond Buyer Municipal Bond Indices (MBI): Bond Buyer is an independent information resource that serves the municipal debt markets on various topics; it publishes its daily newspaper covering municipal debt markets and also publishes indices to reflect the prices and yields on different groups of municipal debt. The bond buyer index (MBI) provides a great snapshot of yields for 40 recently issued actively traded municipal debt instruments. This index is adjusted twice every month to reflect new issues and take out issues that have become less active in the market. This index is often used by many issuers across the U.S. to gauge the market supply and demand for municipal debt in the U.S. and how that will impact their own pricing of debt.
- Bloomberg Barclays Municipal Bond Index: These indices cover the various possible issuances: pre-funded debt, insured debt, general obligations and revenue-backed debt. All comprised debt instruments must have an investment-grade rating by at least two of the three rating agencies: Fitch, S&P and Moody’s.
- Standard & Poor’s National AMT-Free Municipal Bond Index: As mentioned earlier, many investors gauge the market performance of equities based on the S&P 500 Index; however, S&P’s National AMT-Free Municipal Bond Index provides a comprehensive overview of the investment-grade tax-exempt U.S. municipal bond markets. It tracks and measures the performance of over 8500 bonds with over $600 billion in par value.
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The Bottom Line
There is an index for virtually any and every investment in the capital markets for investors to use in their analysis of a potential investment. In addition to providing a general snapshot of the market and helping investors make an informed decision, indices play a critical role in evaluating and tracking the markets to observe the trends and how they can possibly impact your investments.
Investors must thoroughly understand the characteristics of the investment instrument under evaluation and look for an appropriate index to gauge the overall average performance in the municipal debt markets.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisors prior to making any investment decisions