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Incorporating Liquidity Measures in Constructing a Corporate Bond Index Which measures can help create more replicable and tradeable bond indices?

Much has been written about the tradability and investability challenges of broad-based fixed income indices that contain thousands of bonds. Traditionally, fund managers seeking to replicate the returns of such indices typically choose a sample, holding a small fraction of the bonds. Tracking error to the benchmark may be managed by matching key risk characteristics, such as credit rating, sector, duration, convexity, and yield-to-maturity of liquid and available bonds.

In this paper, we examine liquidity criteria that can potentially be used in the construction of replicable and liquid fixed income indices. We used the S&P 500® Investment Grade Corporate Bond Index, which contains more than 4,500 bonds and can therefore face the aforementioned replicability challenges, to guide the development of a framework for forming a narrower, investable basket. We then compare the liquidity profile of the resulting index, the S&P/MarketAxess Investment Grade Corporate Bond Index, to the benchmark.

In assessing the relative liquidity of bonds, we examine the strength of commonly used indicators, such as size and age, against Trade Reporting and Compliance Engine (TRACE) corporate bond transaction data. Additionally, we examine the persistence of TRACE-based liquidity signals over time to develop a systematic approach in constructing a tradable subset while controlling for turnover.

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