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The case for dynamic fixed income exposure

5 February 2019

The concept of alternative and systematic approaches to equity investment is a richly mined area of research that has been explored for decades, but it has yet to receive the same level of focus and innovation in the fixed income universe. For more than a decade, GAM Systematic has been exploring the opportunities to develop a rules-based approach, which aims to benefit in both bullish and bearish credit environments.

The calendar year of 2018 proved a particularly challenging one for investors – especially in the context of the lengthy bull markets in stocks and bonds that preceded it. By the end of December, key equity indices in the US and the UK had registered double-digit declines from their respective 2018 peaks, while Germany’s DAX endured a peak-to-year-end slump of almost 25%.

The pace of the ‘normalisation’ of US monetary policy, in the form of quantitative tightening and persistent rate hikes, also provided a sense of consternation in fixed income markets. Credit spreads widened over the course of the calendar year as investors paused in their hunt for yield, concerned about the potential for credit to weaken further.

Clearly, in 2018, investors could have benefited from incorporating strategies beyond traditional long equities and long fixed income which remain dependent on global growth and interest rates, both of which endured a difficult year with the outlook also remaining challenging.

This leads us to the concept of alternative and systematic approaches to investment. This is a richly mined area of research that has been explored for decades with regards to equities, but it has yet to receive the same level of focus and innovation in the fixed income universe. In the following, we explore the opportunities of diversifying fixed income exposure by including such a systematic credit approach, which aims to benefit in both bullish and bearish credit environments.

A late-cycle, post-peak environment?

It is often claimed that active security selection, as well as timing, is especially capable of adding value in a late-cycle, post-peak environment. In many a bull market, positive sentiment drives broad price momentum and creates a rising tide that lifts all boats somewhat indiscriminately, and can thus favour beta outperformance over active management. This dynamic fades once we reach the late-cycle and post-peak phase as investors begin to question the prior economic growth assumptions. Investors then begin to time exposures and select individual securities (equities, credit, etc.) which they believe will better weather the late-cycle pressures. And indeed, in such a post-peak environment, investors are well served in selecting more carefully where they place their investments, as some positions will fare far worse than others. This is recurring, post-peak price behaviour which we have witnessed repeatedly in past cycles.

In equity markets, active investors focus on timing or gross exposure levels and metrics such as relative earnings per share, the sustainability of dividends, corporate cash flows, pricing power and innovation in order to try to discern winners from losers. Similarly, in fixed income and credit, active traders consider these timing and fundamental metrics along with additional factors which typically drive relative credit prices, for example credit quality (likelihood of default in terms of principal or coupon) and duration (sensitivity of an individual security or instrument to rising interest rates). Both these credit-specific risk factors tend to increase in a post-peak environment, leading to investment timing becoming an increasingly important consideration.

As systematic investors, we benefit from having the scientists, the data, the analytical tools and the trading systems to analyse both the timing question and the relative value picking question efficiently. As such, we are able to implement dynamic adjustments in accordance with shifts in the prevailing trading environment.

A dynamic, systematic approach to credit

After more than a decade of scientific investment research, we now apply our systematic investment approach to the credit space, with a view to outperforming in most market conditions. We have a particular focus on mitigating pain in a sustained negative credit environment. Systematic approaches utilise the ability to analyse vast amounts of market data in real time in order to create investment strategies to navigate changing market conditions. As we built our approach to systematic credit, we created three sub-strategies, each of which focuses on particular credit return drivers: tactical credit acts like an active credit trader, while directional credit acts like a credit strategist, taking medium-to-longer term views of the credit environment. The third strategy, market neutral credit, acts like a credit analyst, taking relative value positions in one security against another. In terms of philosophy, these three complementary approaches can be systematically aggregated to create a dynamic strategy that is potentially fully risk-on or fully risk-off (and any combination in between) in accordance with market conditions.

Tactical credit: The systematic ‘credit trader’, which forms the core of our tactical credit sub-strategy, focuses on identifying changes in credit market sentiment and is quick to move from credit exposure into safe haven bond exposure when credit markets appear to be weakening. Conversely, as the credit environment subsequently stabilises, it is important to dynamically reallocate to investment grade and high yield credit to capture the greater yield and returns of credit versus safe-haven bonds.

Directional credit: This component is focused on the medium-term environment for credit. It is reactive to sustained changes in credit spreads and takes long and short positions in accordance with the strength of the supportive signal. The directional credit signals take into account autocorrelation and other evidence of buying pressure on credit which manifests as momentum in prices and credit spreads. While momentum has been observed and studied across many asset classes and timeframes, detailed statistical analysis and academic research1 reveal that this auto-correlated price behaviour is especially evident in credit markets. Directional credit is by design looking at longer term credit environment shifts and its style is slower, or more strategic than tactical, in execution.

Market neutral credit: While the first two sub-strategies of our credit portfolio are directional by design, the third is based on a relative value approach looking at single-name credits. The sub-strategy selects long and short positions which appear to offer the best relative value, while remaining market neutral in aggregate. The market neutral component utilises the sophisticated cross-asset infrastructure we have developed over the past 10 years, trading a combination of proprietary credit fundamental factors to identify idiosyncratic investment opportunities. Market neutral credit aims to capture future changes in the relative performance between individual issuers and tends to hold positions for a longer period of time than the tactical and directional credit sub-strategies.

We combine the signals from these three sub-strategies – tactical credit, directional credit and market neutral credit – to form our final credit portfolio. We employ a completely data focused, rules-based philosophy that aims to generate credit-like returns in favourable credit market environments while also having the potential to deliver substantial downside insulation during bearish credit conditions. The three sub-strategies are independent, distinct, and largely uncorrelated return drivers that differ in terms of investment horizon, style, directionality and risk exposures.

As such, they can, in combination, provide a useful source of diversification for any traditional fixed income and credit allocation. The increasingly prevalent view within the investment community is that the challenging market environment of 2018 – with late cycle indicators arguably abundant – is likely to extend into this year and longer term. The ability, therefore, to insulate a portfolio’s expected downside is likely to be considered an increasingly valuable attribute in helping investors meet their long-term objectives.

1‘Momentum in Corporate Bond Returns’ Jostova et al (2010)
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Allocations and holdings are subject to change.
Important Information on Systematic Investing
Systematic investment strategies are speculative and are not suitable for all investors, nor do they represent a complete investment programme. Many of the investment programmes are speculative and entail substantial risks. Systematic investment strategies include the risks inherent in an investment in securities, the use of leverage, short sales, options, futures, derivative instruments, investments in non-US securities and “junk” bonds. There can be no assurances that an investment strategy (hedging or otherwise) will be successful or that a manager will employ such strategies with respect to all or any portion of a portfolio. Investors could lose some or all of their investments.
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