The slow reaction of bond indices November 5, 2013 at 6:41 am

From Goldman’s Jesse Edgerton, via FT alphaville:

In the current iBoxx US investment grade index, for example, about 15% of bonds in the index trade less than once a month, and only about 65% trade on any given day. Even fewer bonds trade multiple times per day in substantial sizes. Thus prices and yields for a large fraction of the bonds that are aggregated into published indices must be estimated by the providers of the index data each day.

Unfortunately, it appears that the procedures used to estimate these prices do not incorporate all information available on each day, because future movements in bond indices are easily forecastable well into the future. To illustrate, we regress daily changes from 2010 to present in the Bank of America-Merrill Lynch BBB index yield on contemporaneous and lagged daily changes in 5-year Treasury rates and daily changes in spreads on the 5-yr CDX index of corporate default swaps, a more liquid credit market instrument… Although information reflected in Treasury yields is incorporated into the index quickly, information in CDX spreads is incorporated very slowly. A 1 bp increase in the CDX spread accompanies only a 0.1 bp increase in the BBB index yield on the same day, but it predicts an increase of another 0.3 bps on the following day and further increases up to three weeks later.

This is more important than I have space for, really, so just a few hints:

  • This lag poses a serious methodological challenge to a lot of quantitative work which uses bond spreads – the delays need to be accounted for, and the slow response will be difficult to disentangle from other factors.
  • There might be the nub of an arbitrage here, if you could figure out how to do index arb safely on an index with illiquid components.
  • Issues like this may well get worse, as regulation makes market making more expensive. This is going to present growing opportunities for players willing to take asset illiquidity risk.

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