Systematic credit investing strategies have become increasingly popular among fixed income investors. By taking a quantitative, model-driven approach, these strategies aim to maximize returns while effectively managing credit risk. One example is a risk-managed fixed income value strategy that selects undervalued corporate bonds based on credit fundamentals. This article will examine the key characteristics and implementation of such a systematic credit strategy.
Screening process targets undervalued bonds
The first step is screening the investment universe, typically composed of corporate bonds, to identify securities with attractive valuations. The model incorporates fundamental credit factors like leverage, interest coverage, and asset valuation to determine a credit score for each bond. Securities with higher scores have stronger credit quality while lower scores indicate bonds trading at a discount to fundamentals. By selecting undervalued bonds, the strategy targets credit spread tightening and rising bond prices.
Risk controls manage volatility and drawdowns
In addition to targeting cheap bonds, the strategy also actively controls for risk to provide downside protection.Limits on sector, rating, and issuer concentration promote diversification. Minimum liquidity criteria ensure the portfolio can be traded efficiently. The model also caps interest rate duration to moderate interest rate sensitivity. Drawdown control metrics limit the maximum loss if a bond defaults. These constraints allow the strategy to benefit from credit risk premia while avoiding excessive volatility.
Research identifies persistent drivers of credit returns
The effectiveness of the strategy depends on systematically targeting the key drivers of corporate bond performance. Extensive research has identified credit-specific factors with robust explanatory power for future returns. Value metrics like credit spreads and distance-to-default exploit the tendency for credit spreads to revert to fair levels over time. Momentum indicators reflect trend continuation in bond prices and credit spreads. Carry measures take advantage of higher income from lower-rated bonds. By targeting multiple factors, the strategy can provide high information ratios and consistent alpha.
Portfolio construction integrates alpha signals
The final portfolio is constructed by integrating the alpha signals from multiple factors into a unified signal ranking bonds by their return potential. Risk constraints are applied to ensure appropriate diversification and risk control. The resulting portfolio is rebalanced monthly to maintain exposure to the best opportunities. This disciplined, model-driven approach allows the strategy to systematically harvest the credit risk premium across market environments.
Case study demonstrates effectiveness since 2001
AQR Capital Management evaluated a live track record for a U.S. corporate bond strategy following this systematic value approach from September 2001 to December 2020. The strategy generated consistent positive alpha over Treasuries with an information ratio above 1, demonstrating its ability to consistently exploit mispriced credit. The strategy also effectively managed risk, with significantly lower volatility and maximum drawdown than the overall corporate bond market. This case study illustrates the merits of a systematic multi-factor approach to credit investing.
In conclusion, systematic credit strategies like value-based bond selection can potentially improve fixed income returns while managing portfolio risk. By targeting undervalued bonds with attractive credit fundamentals, imposing diversification constraints, and balancing multiple factors, these model-driven approaches aim to maximize risk-adjusted returns in an efficient, scalable process.