By Vuk Magdelinic, CEO, Overbond
It’s a challenging time for fixed income investors. A 40-year bull market in bonds saw US 10-year Treasury yields fall from almost 16% to less than 1%. They are still lingering near record lows and in major European markets 10-year rates are negative or barely positive. At the same time, spreads on investment grade and high-yield bonds are historically tight. These low rates and tight credit spreads are expected to persist for years.
Investors are searching for yield
Investors searching for higher yields in this low-rate environment have been extending duration in credit and moving into lower-rated investment grade, emerging market and high yield bonds. But this introduces increased credit and liquidity risk and reduces diversification benefits as these lower-rated securities are more highly correlated with equities. These investors are achieving higher yields through greatly increased risk and, with spreads as tight as they are, they’re not being properly compensated.
But not all fund managers are following these strategies. Some have used the diligent selection of individual corporate bonds to outperform without taking on excess risk. This requires some form of relative value or rich-cheap analysis.
Market structure has changed
Concurrent with this challenging yield environment, there have been dramatic changes in fixed income market structure. New products such as ETFs, the emergence of electronic all-to-all platforms and non-dealer liquidity providers using algorithmic and high frequency trading are among the developments re-shaping the industry and creating new sources of corporate bond liquidity. Major electronic bond trading platforms reported record trading volumes in 2020, including record trading of U.S. and European corporate bonds — for which e-trading has grown dramatically in the last decade.
Quant trading is growing on the buy-side
The increased electronification of the markets has created more useable and accessible trade data. This increase in both real-time and historical transaction data has made it possible to aggregate large amounts of data for each client in real time for use by AI tools. New sources of corporate bond liquidity, the availability of richer data sets, the electronification of bond trading and the development of more powerful AI with cloud computing have now made purely quantitative bond trading execution possible. Even quantitative hedge funds have been moving into the fixed income space.
Beyond hedge funds, electronic trading and the use of AI for trade automation have become the new standard for buy-side desks and are a prerequisite for remaining competitive. Buy-side desks are spending heavily on technology and increasing their use of AI for analytics and automated trading. And they’re increasingly turning to quant trading in fixed income to add alpha and enhanced beta using strategies that isolate factors such as carry, momentum, quality and volatility and by applying quant modelling to directional, yield curve and rich-cheap analysis.