Index Driven Price Pressure in Corporate Bonds

Abstract

Inclusion and exclusion of bonds from major indices are information-free, monthly events. At these events, liquidity providers get a significant abnormal return by trading against index trackers. The return is highest for bonds that are excluded because of a recent downgrade with a one-day return of 356.2 bps (T-stat 2.82). Liquidity provision at exclusions is more profitable than at inclusions because index trackers follow a sampling strategy and returns also increase when liquidity provision becomes more expensive. Furthermore, price reactions following index changes are reversed shortly after the event date which indicate temporary price pressure.