“Distortive Effects of Benchmarking by Fixed-Income Funds”

I show that benchmarking concerns of fixed income funds lead to distortions in corporate bond prices, due to portfolio re-balancing in response to changes in the benchmark index. Risk-averse fund managers trade off hedging demand for illiquid assets in the benchmark against cash demand in expectation of future redemptions.  On average, bond funds react asymmetrically to index re-balancing, using cash to buy assets with the highest weight increases, and not selling as much those with the largest decreases. These reactions generate an alpha of 39.5 bp on a monthly basis, beyond standard pricing factors. Bonds held by funds previously hit by extreme redemptions are sold more, with large negative price impacts on assets with strong past index weight decreases. My findings suggest benchmarking could be an amplifier of instability in fixed-income markets, especially during periods of distress.