Paul Benson, head of Systematic Fixed Income, Insight Investment, writes that systematic fixed income approaches are finally hitting the mainstream. If you are starting to incorporate them, make sure your managers have a long and proven pedigree, he says.
Although my team has been developing systematic fixed income approaches since 2001, only lately have we seen exponential growth in these types of strategies.
Barclays research estimates that USD90 billion to USD140 billion of capital is being managed in systematic credit vehicles and their popularity has exploded over the last two years.
Systematic investing is far from new to equities. In 1973, Tom Loeb, who I had the fortune of working with at Mellon Capital Management, launched the first equity index strategy to make use of quantitative factors.
But things really took off in the 1990s. Nobel-winning economist Eugene Fama published his highly influential three-factor model.
At the same time, the end of the Cold War meant that mathematicians and scientists were less able to find employment in the defence sector, instead turning to a booming Wall Street. The phrase “quant” entered the financial lexicon and factor-based investing became increasingly common in equities into the 2000s.
But during this time, bond markets remained old fashioned by comparison. Even today, a lot of trading is done one bond at a time.
Worse, this type of trading became less liquid in the post-2008 regulatory environment. In high yield bonds, it can take days or even weeks to find the other side of a trade, with transaction costs of 50 basis points (bp) to 70bp on good days or north of 300bp in stressed markets.
Liquidity is a clear limitation of traditional passive and active strategies. In the US high yield market for example, our analysis of the eVestment database shows that most passive strategies only tend to hold 60 per cent of the 2000 bonds in the broad US high yield index, and active strategies generally hold 15 to 30 per cent.
As a solution, we pioneered ‘credit portfolio trading’ over a decade ago, aiming to unlock hidden liquidity within the fixed income ETF ecosystem. We find we can bring US high yield transaction costs down to 10bp to 20bp while trading as much as USD500 million daily, with execution times from minutes to hours, even for less traded and traditionally illiquid bonds. It makes investing in 90 per cent or more of an index entirely realistic.
Another limitation of traditional strategies is the analytical burden. Fundamental active managers rely on credit analysts to avoid defaults and implement active positions. But with over 900 unique issuers in the US high yield market alone, even the most well-resourced credit teams can only cover a fraction of them. It generally means managers take relatively few alpha positions, while keeping them conservative because of the enhanced impact a default would have.
However, a systematic approach can automate credit analysis. Models are tireless, fast and repeatable, so analysing an entire bond universe is no big deal. Instead of a few, concentrated positions, a portfolio can implement numerous ‘micro’ active positions or tilts across its portfolio when seeking alpha.
Of course, any model needs to be well calibrated with a sufficient quality of data. The good news is that credit models are not new, albeit infamously difficult to practically implement. For example, Robert Merton’s Merton model, designed to pinpoint a company’s default risk, was published in 1974. However, the model needs tweaking for use in the real world, so due diligence on managers implementing these processes is essential.
We expect systematic fixed income strategies to continue to grow in popularity. However, investors need to work with those with proven credentials, experience and track record of applying systematic investing to fixed income.
Systematic fixed income investing is not a panacea, but it offers clear advantages in some asset classes, particularly areas that are less liquid, such as high yield.
Systematic approaches can perhaps also offer compelling diversification against traditionally managed strategies. For example, we find that 72 per cent of fundamental active high yield strategies have an alpha correlation of 0.5 or above with the average manager (limiting the potential benefits of manager diversification). Our strategy, by contrast has had an alpha correlation of less than 0.25 with 90 per cent of the fundamental active US high yield manager universe – based on our analysis the eVestment US high yield fund universe from April 2013 to March 2023 – and a negative correlation with 60 per cent of it.
If you have not already, it is time to think about how systematic fixed income might help you better address the challenges you face, and potentially be delivering more reliable returns and enhanced liquidity.
Don’t miss out on the digital revolution in bonds.
