Credit-Based Alpha Investment Strategies and Risk Management

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Investors’ search for better risk-adjusted returns has also permeated the fixed-income index market. The number of products is growing, boosted partly by smart beta and other quantitative strategies which have begun to include fixed-income investments.

Among the challenges though is that usual factors behind equity returns (some are included in pricing models) are less easy to identify among fixed-income assets, while finding appropriate benchmarks is also more difficult in the fixed-income space.

As central banks have sought to revive economic growth in the wake of the global financial crisis, interest rates have been kept artificially low, particularly in developed economies. This low interest rate environment has prompted investors to look for better returns in the fixed-income space.

Fixed-income strategies which seek alpha returns often target high-yielding corporate bonds and emerging-market debt. They can also focus on sectors which offer the best risk-adjusted returns, though many products offer multi-sector exposure.

Since high yields are often a function of high credit risk, careful issuer selection – based on analyses of quality – is an essential part of risk management. While a high-yield fund might target non-investment-grade debt, these funds are often diversified by including investment-grade debt and securitised debt.

Apart from default risk, alpha credit strategies are prone to usual fixed-income risks such as inflation. Some bond strategies protect against inflation risk, including US Treasury Inflation-Protected Bonds. The correct management of these and other risks is an important part of developing sound fixed-income alpha strategies.

Smart beta and fixed income

Until recently, smart beta providers tended to overlook the credit and fixed-income markets, choosing to rather focus on other asset classes, usually equities and commodities. This is partly due to the fact that fixed-income instruments such as bonds can be difficult to include in a rules-based index. As a result, a number of fixed-income indices are employed only as non-investable benchmarks.

However, the growing demand for passive and semi-passive investments means smart beta providers are increasingly turning to the fixed-income sector. The opportunity is large, given the sheer size of the fixed-income market relative to equities.

Smart beta refers to alternative index construction based on a set of predefined rules. Indices are sometimes built using the same constituents as usual market benchmarks, but assigning different weightings to constituents in order to deliver better returns or to control risk.

Sometimes also referred to as custom indices, smart beta aims to deliver superior risk-adjusted returns with the help of quantitative analyses that identify the underlying factors behind high returns.

In the case of smart beta, alpha (or excess) returns imply superior strategy selection and index construction, while alpha in the world of mutual funds suggests skilled stock selection or fund management.

Benchmarking fixed-income funds

The performance of a smart beta fund is compared to a relevant benchmark. In the case of equity indices, a fund might be measured against a benchmark index like the S&P 500 index of large US stocks. These indices are weighted by constituent size.

Equity benchmarks have a natural bias towards stocks with big market capitalisations. On the other hand, fixed-income benchmarks are weighted by liability, meaning they have a bias towards highly-indebted issuers. In the case of sovereign debt, this means that benchmarks have a large tilt towards countries like Japan, which have high debt-to-GDP levels. For corporate debt, this means a bias towards high-issuing companies, which is not always a good thing from a risk perspective. Further, it creates biases towards certain sectors which require more debt than others.

The bias towards indebtedness has put some investors off traditional benchmarks – providing an opportunity for smart beta providers to wade into the fixed-income market and target the inefficiencies of usual benchmarks.

One of the more popular fixed-income smart beta strategies is to weight index constituents by GDP rather than by levels of indebtedness. This strategy naturally increases the weightings towards countries with lower levels of debt, which helps to alleviate default risks.

But usual factors behind superior returns – such as value, momentum, volatility and size – are less easy to identify than in equities.

Benchmarking itself is not an easy task in the fixed-income world, partly because

Beta and alpha are used by investors to measure investment risk and performance. Beta refers to the volatility risk of an investment relative to the market. Alpha refers to the excess returns of a security or portfolio, where a positive alpha value points to outperformance relative to the benchmark and a negative alpha means a fund’s performance was worse than the market.

The challenges of including fixed-income in smart beta funds

Fixed-income is a more difficult asset class for smart beta providers to target for a number of reasons, including liquidity constraints. Many debt issuers also have a large number of instruments in the market, each with potentially different ratings and maturity profiles. This is problematic for the rules-based nature of smart beta investing.

Beyond smart beta

Meanwhile, some risk premia funds also target the fixed-income sector. Risk premia investing uses long-short trades to generate absolute returns irrespective of market conditions. Like smart beta, this strategy is based on factor investing techniques.

Spurred by regulatory changes to banking models, uncertainty about the Eurozone and its members, and the unsteady rise of many emerging markets, the volatility of fixed-income markets has provided alpha-generating opportunities for these types of strategies.

The fixed-income arbitrage strategy, meanwhile, is a tool used by the hedge fund industry to generate returns from inefficient bond pricing. Like risk premia strategies, hedge funds use long-short trades to generate absolute returns.

Fixed income forms a core part of actively-managed mutual funds. The standard mutual fund includes exposure to the equity fund market, fixed-income market and the money market.

But this trend is also becoming evident in the smart beta sector, which has seen some consolidation.