How do bond indices handle illiquid issues?

Question

AcadiFi · Accepted Answer

Index providers screen for minimum liquidity to ensure replicability and pricing quality. Typical thresholds include: minimum amount outstanding (e.g., $300M for Bloomberg Global Aggregate investment grade, $500M for High Yield index) to ensure enough float for multiple institutional holders; minimum remaining maturity (1 year to exclude near-maturity bonds where trading collapses); and credit rating minimum (BBB- from at least one major rating agency for investment grade).

Rationale: bonds below thresholds trade infrequently, have wide bid-ask spreads (often 100+ bps), and are priced via matrix pricing rather than real transactions. Including them would degrade index tradability and introduce valuation noise.

Seasonality and structural liquidity: on-the-run Treasuries trade with bid-ask of 0.5 bp; off-the-run Treasuries widen to 2-5 bps. Corporate bond liquidity follows a 'life cycle': heaviest trading in first 3 months post-issuance, declining sharply thereafter. For a $700M corporate bond, average daily trading volume might be $5M in month one, $1M by month six, and $200k by year two.

Index providers update liquidity screens: Bloomberg has added filters for 144A Regulation S availability to global-facing indices; ICE applies minimum monthly trading volume for its high-yield constituents.

For a fund like Crispinford Fixed Income tracking a liquid index subset, choosing the right index (LiquidAggreate vs Aggregate) dramatically affects transaction costs: liquid subset indices offer 20-40 bp tighter trading but 5-15 bp higher tracking risk versus the broader universe.

How do bond indices handle illiquid issues?

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