With the development of financial markets, systematic investing in credit has become an important part of many investment portfolios. Systematic credit investing aims to efficiently diversify credit risk and improve risk-adjusted returns. By using quantitative models and rules-based processes, investors can gain broad exposure to credit markets in a structured way. However, there are also risks associated with this approach that need to be understood. This article will explore the rationale, strategies, benefits and risks of systematic investing in credit.
Credit carries risk premiums that can be harvested
Credit instruments like corporate bonds tend to offer extra yield over comparable government bonds to compensate investors for default risks. These credit risk premiums have historically provided positive excess returns over the long run. Systematic credit strategies aim to efficiently capture these risk premiums through diversification. By holding a broad basket of credit assets, idiosyncratic risks can be minimized while preserving the credit premium.
Models screen for cheap vs expensive credits
Systematic credit investing relies on quantitative models to screen the credit universe for cheap versus expensive securities. Factors like credit spreads, default risk models and balance sheet metrics are analyzed to identify mispricings. Securities deemed undervalued are purchased while overvalued ones are avoided or sold short. The models impose discipline and help construct diversified portfolios tilted towards systematic alpha sources.
Rules-based execution minimizes biases
By following a rules-based process for security selection and portfolio construction, human biases can be minimized. Unlike discretionary credit investing, there is no need for investors to manually evaluate each credit. Systematic execution also allows for more diversification and responsiveness to new information. Portfolios are rebalanced periodically based on model outputs rather than gut feelings.
Broad exposure improves diversification
The universe for systematic credit investing is far wider than what individuals can analyze. The models allow exposure across investment grade, high yield, emerging markets, structured products and other niches. Such broad diversification reduces concentration risks and volatility compared to narrowly focused credit portfolios. Large institutional investors increasingly use these strategies as complements to mainstream credit funds.
Overreliance on models poses risks
While systematic credit strategies have benefits, there are also limitations to relying solely on quantitative models. Unforeseen events outside the models’ assumptions could lead to unexpected losses. And if other investors employ similar models, crowding risks arise. Systematic strategies should therefore be blended with other active or passive approaches. Understanding the models and their underlying assumptions remains crucial.
In summary, systematic investing enables efficient harvesting of credit risk premiums through disciplined quantitative models and broad diversification. But overreliance on models can be risky. Investors should understand the assumptions and blend systematic credit strategies with other approaches.