As stock investors use stock indices to estimate the state of the stock market, investors who hold bonds monitor the reports of bond market indices to gather information about the bond market. A bond market index reports a number that it calculates using the prices of a certain set of bonds. By tracking the movements of these numbers from day to day, investors can get an idea of the movement of the market as a whole.
An index is a listing of assets that are weighted according to some factor. Often, assets are weighted according to the share of the market they represent. The index reporting agency calculates a number using the prices of those assets. The number in itself is meaningless because its magnitude depends on the decisions made by the agency that reports it about how to calculate it. Investors pay attention to movements in the index as percentages of the total number.
A bond market index draws its data exclusively from bonds. A bond is a debt instrument, while stocks are equity instruments. Buying a stock gives an investor partial ownership of a company’s future profits. Buying a bond is essentially loaning the company the purchase price of the bond in exchange for future payments. In the secondary bond market, investors sell those loans to each other. Like most loans, bonds have maturity dates and scheduled repayments.
Some of the reporting entities that have reliable and well-known stock indices also have bond market indices. Standard & Poor’s National AMT-Free Municipal Bond Index is reported by the same entity that generates the stock market’s S&P 500 Index. Dow Jones also reports several bond market indices.
Bond indices can have different characters based on the bonds they include in the index listing. Some concentrate on government bonds, for example. Funds that use an indexing approach to build their portfolios can base their holdings on widely recognized indices or devise their own. When a fund does create its own bond market index, it is often designed using enhanced indexing techniques.
Other financial instruments can be based on a bond market index. For example, index funds draw their value directly from the performance of the underlying index. In contracts, like leases, payment streams can be tied to an index using an embedded derivative. Derivatives are usually based on robust indices that are accepted as reliable indicators of the bond market’s movement.