Corporate Bond Indices

June 22, 2012

Deutsche Bank offers an index which provides exposure to corporate credit risk through CDS while controlling interest rate risk using sovereign bonds. The index includes a portfolio of sovereign euro bonds and an exposure to the change in the level of corporate credit spreads (a portfolio of CDS on corporate issuers).

Lastly, Accretive Asset Management offers the “BulletShares USD Corporate Bond Indices”, which measure the performance of maturity-targeted segments of the US investment-grade corporate bond market. Each index tracks a basket of bonds with the same annual maturity and replicates a profile similar to that of an individual held-to-maturity bond, resulting in a series of fixed-income indices with successive annual maturities (from 2012 to 2021).

LIQUIDITY RISK

Benchmark indices generally consist of a very large number of bonds, which makes them difficult to replicate. Furthermore, bonds with special features or smaller amounts outstanding usually suffer from illiquidity, resulting in relatively large bid-offer spreads (Bias et al. 2006), especially during times of stress. For instance, Nielsen et al. (2011) show that corporate bond spreads increased dramatically with the onset of the subprime crisis. Old issues also tend to be illiquid as investors focus on newly issued bonds. Some corporate bond indices aim to address these deficiencies by limiting the number of bonds per index and excluding special bond types and old bonds, thus increasing liquidity.

The recent EDHEC-Risk European Index Survey12 shows that for corporate bond indices, liquidity risk is the most critical concern: 68.3% of respondents regard it as important or very important and only 2.4% do not worry about it at all.

Lack of trading and transaction data are a common feature for bonds, so it is especially important to monitor liquidity when selecting the components of a bond index. In fact, many studies have attributed deviations in corporate bond prices from their theoretical values to the influence of illiquidity in the market. Huang and Huang (2003) find that yield spreads for corporate bonds are too high to be explained by credit risk and question the economic content of the unexplained portion of yield spreads (see also Colin-Dufresne, Goldstein, and Martin (2001) and Longstaff, Mithal and Neis (2005)). Bao and Pan (2008) document a significant amount of transitory excess volatility in corporate bond returns and attribute this excess volatility to the illiquidity of corporate bonds. Bao and Pan (2011) also show that the illiquidity in corporate bonds is substantial, contributing to higher bond yield spreads than might be expected from bid–ask spreads alone. They find that the aggregate illiquidity explains the monthly changes in corporate yield spreads, all the more so for ratings A and above, where the illiquidity is by far the most important variable, explaining over 51% of the monthly variation in yield spreads for AAA-rated bonds, 47% for AA-rated bonds, and close to 60% for A-rated bonds. They also compare illiquidity-implied spreads with the estimated bid-ask spreads reported by Edwards, Harris, and Piwowar (2007). Bao and Pan find that estimates of implied spreads are between 50% higher and almost four times higher than those by Edwards, Harris, and Piwowar, depending on the size of the transaction.

 

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