Why does an issuer-capped bond index overcome the bum's problem?

What will be an ideal response?

The bum's problem is the problem associated with the notion that benchmarks (like a market-cap-weighted bond market index) are dominated by large issuers and thus have firm-specific risk related to these large issuers. If these issuers undergo subpar performance, then the variability of returns will increase in a negative way affecting the performance of a bond manager's portfolio. To deal with concentration risk for the purpose of avoiding idiosyncratic risk and thus overcome the bum's problem, bond indexes have been created by their developers that impose a cap (i.e., a maximum amount) on the weight for a given issuer in a corporate bond index or a given country in the case of an international government bond index.

To illustrate how to overcome the bum's problem, the Barclays Capital U.S. Corporate Aaa-A Capped Index imposes a 3% cap on any individual bond issue's weighting. In the Barclays Capital Global Treasury Index that is an index of government bonds throughout the world, two countries constitute more than 50% of the index by market cap: the United States and Japan. That index has been customized to reduce the weight assigned to those two countries, as well as to regions. Although imposing an issuer cap might sound simple, care must be taken to determine how the cap can impact the risk-return profile of the capped-issuer index. One study has analyzed how an issuer-capped bond index can unintentionally introduce unfavorable sector and credit risks compared to an uncapped bond index.