The construction of fixed-income exchange-traded funds (ETF), due to be launched in the first half of this year, is facing a number of challenges that are likely to result in products that are quite different from provider to provider.

Unlike equities, bonds are not listed on an exchange and this creates challenges to liquidity of fixed-income products and the pricing of the securities.

Fixed-income indices also contain underlying securities that are much larger than equity indices.

Where shares of ASX 300 companies can be as cheap as a few cents, the minimum size of a bond to be listed in an index is $100 million, and you cannot just buy a small portion.

To replicate these indices was far more complex than replicating an equity index, according to State Street, one of the companies looking to launch bond ETFs later this year.

"It is at times difficult to use fixed-income indices, because some of them are very large with regards to underlying [assets]," State Street Global Advisors managing director Frank Henze said.

"Let's say, for example, out of the aggregate bond series from Barclays Capital we have a number of components out of Europe and the US with several thousands of lines of underlying securities.

"That is the challenge for the investment manager to make sure that with a very shortened portfolio you achieve the return of the index.

"Not everyone can produce good fixed-income ETFs. You have to have a little bit of skill and track record in that field."

There was no one-size-fits-all solution, he said.

"It is important to remember that the objective of the product is to deliver index return in a way that allows liquidity in the product and minimises tracking error. There aren't really any specific techniques that work in any case," he said.

But Vanguard head of product management and development Robyn Laidlaw said the issue of scale was also the very reason why fixed-income ETFs might prove to be popular, because they would enable investors better access to the market.

"It is probably an advantage to investors in the same way that it is an advantage for equities," Laidlaw said.

"Buying shares in all the top 300 ASX listed companies requires a lot of money, but we now offer the same exposure through buying $50 units; you are getting that diversified exposure through a unit. The same thing goes for bond products."

For Vanguard, the issue of size is not a problem, because it will manage its ETFs on the back of its existing bond funds, including the Vanguard Australian Government Bond Index Fund and Vanguard Australian Fixed Interest Index Fund, which also include corporate issues.

Vanguard said it expected to launch a fixed-income ETF in the first half year of this year.

"Government bonds are a bit more straightforward, but our largest capability is on the back of the UBS Composite Bond Index," Vanguard corporate affairs and market development principal Robin Bowerman said.

The Australian Securities Exchange has pre-approved two indices: the UBS Composite Bond Index and S&P/ASX Australian Fixed Interest Index.

In October last year, Standard & Poor's also released a new series of fixed-income indices that are expected to be used for new ETFs as well.

Morningstar fund research co-head Tim Murphy said he expected most fixed-income ETFs would not be overly complex, but complexity was largely specific to the individual ETF, rather than an asset class as a whole.

"The UBS Composite Bond Index consists mostly of government and semi-government bonds, plus bonds from the big four banks. They are relatively straightforward," Murphy said.

Besides, he said, equity ETFs could prove to be complex instruments as well.

"If you look at some of the high-dividend equity ETFs, they can be pretty quirky too," he said.

"The iShares (S&P/ASX) High Dividend ETF, for example, has more of a mid-cap bias compared to the other [high-dividend ETFs]."

Institutional investors have also expressed issues with the very nature of bond indices.

A recent survey by Northern Trust showed the vast majority of institutional investors had concerns about the inbuilt biases of capitalisation-weighted fixed-income indices skewing investors to the most heavily-indebted issuers.

"For equity indexes, market capitalisation makes sense," Altius Asset Management senior portfolio manager Chris Dickman said.

"In a general sense, if a company issues more shares, that is good for them because they raise more capital. But if a company issues more bonds, it means they are getting further into debt."

To overcome this problem, State Street runs indices that assess the quality of the issuers.

"We run a product in the US based on an issuer scored index, which effectively looks at the scoring of the issuer and you get a slightly different weighting," Henze said.

But Murphy said the issues with market capitalisation-based indices should not be overstated.

"Last year, the vast majority of active managers underperformed fixed-income indices globally," he said.

"How many of them would have predicted that US treasury yields would fall last year?"