Well-established factors, such as Low Risk, Value, Momentum and Size, generate economically meaningful and statistically significant premiums in credit markets. However, the peculiar structure of these markets entails challenges when it comes to implementing a strategy. We spoke with Mark Whirdy of our Factor Credits team about the way Robeco addresses these issues.
“The main challenge is liquidity: specifically, being able to trade those bonds which maximize factor exposure, as indicated by the model, while keeping transaction costs under control. Unlike equities, the likelihood of finding a trading counterparty for a given amount of a particular corporate bond on any given day is much lower. In other words, credit markets lack immediacy.
This burdens the traders’ workflow. Transaction costs also differ greatly from one bond to another, and you can achieve substantial savings by trading more opportunistically. When constructing a portfolio, we need to maximize factor exposure subject to cost constraints, while complying with allocation and risk requirements.”
“A traditional fully manual investment workflow is incapable of reconciling all these elements. So we had to develop a more efficient investment process that systematically maximizes factor exposure subject to allocation and risk constraints, where liquidity management is actually embedded into the portfolio construction process itself. To achieve this, we leverage on our quantitative expertise in handling big data and drawing inference from it, as well as the expertise of our traders and portfolio managers in navigating OTC credit markets.
In practice, this means we systematically collate a large amount of trading data in real time. We measure both ‘persistent liquidity’, owing to regular two-way flows, and ‘transient liquidity’, owing to short-term dealer positioning. This enables us to only send orders which have a high probability of being executed. This systematic workflow with embedded liquidity management allows us to optimally fulfill the mandate of maximum factor exposure subject to cost constraints.”
We systematically collate a large amount of trading data in real time
“Applying factor strategies to credit markets is a relatively new practice. Robeco can actually be considered as a pioneer in this field. So, our investment process should always be able to adapt to changing market conditions. It requires close collaboration between traders, portfolio managers and quantitative analysts.
For example, when the ECB started buying corporate bonds earlier this year, we were able to promptly adapt to the new supply-side illiquidity environment. We managed to avoid going to market for paper for which the ECB would bid heavily. As our process requires close collaboration between various teams, we can position ourselves to be agile enough to identify and then adapt to market developments and new platforms that facilitate trading.”
This article was initially published in our Quant Quarterly magazine.