Minimum Maturity Rules: The Cost of Selling Bonds before Their Time

Darrin DeCosta, Fei Leng and Gregory Noronha

Financial Analysts Journal, 2013, vol. 69, issue 3, 45-56

Abstract: The authors found that the performance of traditional fixed-income index funds is negatively affected by minimum maturity rules of the indices that the funds seek to replicate. Bonds removed from indices for violating minimum maturity rules underperformed a matched sample in an extended period surrounding their removal, resulting in a 3.5 bp loss in annualized return to the ETF from which the bonds were removed. The authors demonstrate that relaxing the minimum maturity rules could result in improved performance for a popular fixed-income index ETF.The authors examined the effects of a common rule of fixed-income index construction—the minimum maturity rule—and found that it imposes significant additional costs on investors. These costs could be avoided by holding the bonds until they mature.The indices that fixed-income index mutual funds and ETFs seek to replicate are typically governed by a series of rules that determine changes in the composition of the indices over time. These rules cover bond credit quality, minimum par amount outstanding, minimum maturity, and rebalancing frequency. The purpose of these index rules is to define the investable universe of securities and to allow for the creation of low-cost, passive portfolios. The authors found that the implementation of the most basic of index rules, minimum time to maturity, in an index-based portfolio can increase costs borne by the portfolio and thus negatively affect its performance. A simple and obvious change to the index rules to allow fixed-income securities to be held to maturity would alleviate the problem and result in improved investment outcomes for investors.The authors examined the impact of the minimum maturity rule on the performance of a fund—the iShares iBoxx $ Investment Grade Corporate Bond Fund—that tracks a bond index, the iShares iBoxx $ Liquid Investment Grade Index. They compared the returns of bonds deleted from the fund (because of deletion from the index) with those of bonds with similar risk characteristics and found that the deleted bonds significantly underperformed the matching bonds in an extended period around the index deletion event, with the dollar volume of the deleted bonds sold directly related to the underperformance. Their findings suggest the existence of selling pressure, which they estimate to result in an annual underperformance of around 3.5 bps for the fund that tracks the iBoxx index. They posit that selling pressure and the transaction costs of trading bonds in the OTC market can be avoided by relaxing the minimum maturity rule and holding bonds to maturity.

Date: 2013
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DOI: 10.2469/faj.v69.n3.5

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