A benchmark bond is a bond that provides a standard against which the performance of other bonds can be measured. Government bonds are almost always used as benchmark bonds.
A benchmark bond is also referred to as a benchmark issue or bellwether issue.
Breaking Down Benchmark Bond
A benchmark equity, like the S&P 500 or Dow Jones Industrial Average (DJIA), is used to track the performance of company stocks trading on the markets. Stock investors can run a comparison of a company’s shares with a similar equity in the benchmark to understand what level the company’s shares are performing at. The concept of a benchmark bond is similar to benchmark equity, but a benchmark bond works in a slightly different way.
Essentially, the benchmark bond is a security which the prices of other bonds react to. Bond investors and fund managers use the benchmark bond as a yardstick for measuring bond performance and to understand what rate of return to demand in excess of the benchmark return. For a comparison to be appropriate and useful, the benchmark and the bond being measured against it should have comparable liquidity, issue size, and coupon. For example, the 10-year US Treasury bond is mostly used as a benchmark for 10-year bonds in the market. Because Treasury securities are considered to be riskless investments guaranteed by the full faith and credit of the US government, these securities offer a risk-free return. An investor that wants to gauge the return for a 10-year corporate bond, which most likely has more risk than a government bond, will compare the yield to the 10-year Treasury bond. If the yield on a 10-year T-bond is going for 2.85%, the investor will demand a risk premium above 2.85% from the corporate bond issuers.
More specifically, the benchmark bond is the latest issue within a given maturity. While the characteristics of the bond determine the decision regarding what equity to include as a benchmark is made by a committee following broad rules about the operations of the companies represented by a benchmark index, including a benchmark bond or replacing one benchmark bond with another. Characteristics include maturity date, credit rating, issue size, and liquidity. A bond that meets the stated criteria is included as a benchmark. In addition, on the rebalance date, which could change the bond index constituents, bonds no longer meeting the index criteria will be removed, and any new bonds that do meet the criteria will be added.
The Treasury, for example, issues and re-issues 5-year bonds, used as a benchmark bond for 5-year bonds, on a frequent basis. As months and years go by, the 5-year bond maturity date reduces to 4.5, 4, 3.8, 3.7, 3 years, and so on, until it reaches its maturity date. However, in a normal interest rate environment, bond yields go down as the bond approaches maturity. In effect, longer-term bonds have higher yields than shorter-term bonds. Therefore, a benchmark that approaches maturity will be valued at successively lower yields. To bring the yield back up, the government will issue another 5-year bond. This latest issue will replace the older issue as the benchmark bond for 5-year bonds.