The Portfolio Construction Files

The evolution of systematic fixed income

Ahmed Talhaoui |08-Oct-2018


Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Fixed income markets are being disrupted by regulation, technology and shifting liquidity. An emerging understanding of what constitutes alpha, beta, factors, and their relationship with each other in the equity markets has opened fixed income investors’ eyes to new approaches to building investment solutions. Approaches such as systematic active equity have been capturing these trends for years and now similar developments have fundamentally altered fixed income markets. This is creating new opportunities for fixed income solutions that seek to deliver more precise outcomes for investors.

Importantly, a systematic approach involves a deep understanding of what comprises and separates raw market returns (beta), key drivers of market and stock returns (factors), and the added value of market timing, asset allocation and stock selection (alpha). This attribution allows a systematic manager to properly identify opportunities and allocate risk as needed. A wide range of strategies and data sets can be evaluated simultaneously. In fact, a systematic approach thrives on data, and does better in markets where information is readily available.

A critical element of the systematic approach is that such insights are applied consistently through time, through markets and across securities. Cognitive bias and mood swings are essentially removed. A model can improve through time as it is finely tuned and informed by ever more refined signals. Models also bring speed and breadth. The constraints of human attention and processing capability are removed as thousands of changes in fundamentals, prices, and market conditions are monitored per day. This creates breadth in terms of the range of insights that can be incorporated into an investment decision, as well as the number of assets and investment decisions that a systematic process can support.

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Why be defensive?

One common feature among some systematic alpha-seeking strategies, particularly in credit, is that they tend to have defensive return characteristics, and may perform well during periods of equity and risk market decline. For example, in credit the focus is on fully valuing the firm and assessing its overall default probability, from there debt can be evaluated relative to its price. Applied properly, this approach can systematically identify and underweight those issuers more likely to default, resulting in stronger performance during periods of credit dispersion and downgrades.

We feel a defensive approach may be particularly well suited to the current market environment. Corporate leverage is near pre-recession highs, the threat of a trade war is weighing on some markets and our global macro signals indicate increased uncertainty. While we certainly aren’t calling a recession, we do feel these indicators mean a strong grasp of credit quality is going to be important. Highly levered companies are going to be very sensitive to credit quality– so it will be important to properly take that into account when investing in corporate bonds. Credit screening can provide low cost, defensive ways of gaining exposure to the corporate credit markets.

Avoiding losers is more important than picking winners

Today’s low yield environment forces investors to reach for yield and take on more risk. Investors seek income, but want to be defensive about it. Riskier bonds tend to have higher yields, but their risk increases disproportionately. Their ratio of return to risk, or Sharpe Ratio, has historically been lower in the riskiest deciles due to defaults. Thus it is typically more important to avoid losers than to pick winners. Using systematic credit models can help to screen out riskier, lower-quality bonds within sectors and deliver diversified, low-cost portfolios to clients.

Ahmed Talhaoui, CFA
Managing Director, is the Co-Head of Product Strategy for BlackRock's Global Fixed Income Group.

Diversification and asset allocation may not fully protect you from market risk.

Risk management cannot fully eliminate the risk of investment loss.

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