Better Bond Indices and Liquidity Gaming the Rest

Abstract

Security indices are central to modern finance. Because corporate bonds trade infrequently – often less than once a month – corporate bond indices cannot rely exclusively on real time prices, and must instead estimate the value of the market portfolio. While commercial indices do this using proprietary algorithms, we propose using a repeat sales model. Our tests indicate that our repeat sales indices contain information about market values not captured by the commercial indices. We also present evidence that our repeat sales indices more accurately track the true market return. Tests based on trading strategies show that buying and selling securities under the assumption that the commercial indices will ultimately “catch up” to the repeat sales indices produce consistent profits. This is true whether the strategies use individual bond trades, the indices themselves, or mutual funds. It appears that fund managers know the commercial indices reflect stale prices and take advantage of it. Our final tests show that they alter the liquidity of their holdings when doing so may help them avoid reporting poor calendar year returns.