Quant Spring – A new market regime favouring quantitative credit approaches

After many years of low and negative interest rates and extensive market intervention by central banks, markets profoundly changed in 2022. With fiscal spending in response to the Corona pandemic at decade highs, inflation surged higher after many years of deflationary pressures. As a result, monetary policy shifted from supporting markets with interest rates at or below zero and massive liquidity injections (“quantitative easing”) to hampering returns with rapidly rising interest rates and a reduction in central bank balance sheets. What had been a one-way market towards lower rates and spreads suddenly became a volatile combination of rising rates and volatile credit spreads.

Moreover, the political environment has changed dramatically. With the weaponisation of the monetary and financial system, globalisation and Pax Americana have come to an end and a multi-polar world order is emerging. This has profound implications for imported inflation, the cost and security of supply chains and energy security. Feeding back into inflationary and interest rate pressures, the world has changed irreversibly.

This has enormous investment implications for investment grade (IG) credit strategies over the next years. Corporate bond investment styles that were well suited to the previous market regime may struggle to adapt to the new investment world, whereas systematic credit strategies appear to be particularly well positioned to perform strongly in the new market environment. We see the following changes in the markets:

Old era: Carry is king – New era: Carry is risky (again)

With central banks providing a floor to asset prices, every price dip was an opportunity to add to risk positions and participate in the inevitable rebound. The riskiest strategies in IG credit with large high yield buckets, aggressive beta positioning and long carry performed best in this environment.

The chart below shows the dependence of the direction of the spread between traditional fundamental strategies and Quoniam’s quantitative factor strategy, taken from the white paper: Diversifying credit portfolios with factor investing.

As can be seen, the weighted alpha of the fundamentally managed funds in the universe is high when market spreads tighten and negative when spreads widen. The quantitative strategy is less dependent on market direction, with positive performance in all market environments. In the new investment world of increased spread volatility, this independence will stabilise performance and help to avoid large drawdowns.

Old era: Risk management costs performance – New era: Risk management is essential

Since central banks started to support the market with liquidity by buying large amounts of bonds, risk-off periods have been short-lived and shallow. Investors who sold their riskiest positions, for example in March 2020 after the start of the Covid pandemic, regretted their decision only a few weeks later when markets rebounded strongly and rallied for the next 12 months. This was a recurring theme from the end of the global financial crisis to the end of central bank support programmes.

The following chart shows the maximum monthly drawdowns of quantitative and fundamental strategies from the same study mentioned above.

The graph shows that drawdowns in crisis months tend to be much larger for fundamentally managed funds, which are on average more aggressive. While rebounds also tended to be sharp, performance was dependent on markets recovering quickly. In the new investment world, where markets are no longer supported by central banks, this strategy may become problematic. Quantitative funds, with their balanced risk structure, should perform well in such market environments.

Old era: High conviction trades – New era: Granularity and diversification

In the easy money era, diversification was a secondary consideration. With asset prices rising steadily, conviction trades were high and idiosyncratic risk low. Markets often shrugged off negative news, while struggling companies, like everyone else, were lifted by the rising monetary tide.

Now that central bank support for markets is waning, bond selection, diversification of idiosyncratic risk and highly granular portfolios will once again have an advantage. Errors in high-conviction portfolios will be punished more severely than before, and drawdowns are likely to increase.

A special case of this risk awareness is the avoidance of downgrades to high yield within an IG portfolio. Figure 3 shows the percentage of issuers downgraded from IG to high yield for both a global IG credit benchmark and a typical systematic investment fund. In addition to the attractiveness of bonds from a factor perspective, a specific downgrade prediction model can be used to further reduce portfolio risk. In the new investment world of more market-based price reactions, downgrade avoidance will once again become a source of performance.

Old era: Long duration – New era: Active rates management

With quantitative easing and negative interest rates, bond markets knew only one direction: prices rose and yields fell for a decade. Investors who stayed long duration were able to earn extra returns with little additional risk.

The following chart shows the annual volatility of a US Treasury benchmark yield, calculated on the basis of monthly yields.

As can be seen above, the benign volatility environment has given way to a higher volatility regime. With rising rates punctuated by sharp counter-rallies, rates markets need to be actively managed. In the new investment world, factor strategies applied to rates markets should unlock their full alpha potential.

Old era: Central banks provide liquidity – New era: Liquidity management is essential

Liquidity has always been a challenge in corporate bond markets. But with central banks supporting markets and buying bonds, there was a buyer of last resort to which market participants could sell unwanted bonds. Central bank intervention also increased the willingness of dealers to take positions on the assumption that they would be easier to unload.

Figure 5 shows the effect of rigorously incorporating liquidity into the portfolio construction process. The use of indicative pre-trade data increases the number of bonds correctly classified as liquid and reduces the number of bonds incorrectly classified as illiquid. It also increases a fund’s outperformance potential, as we have shown in a recent white paper.

Now that the buyer of last resort has left the market, meticulous liquidity sourcing and its integration into the investment process becomes a success factor for credit managers. Quantitative strategies, with their built-in ability to process large amounts of daily liquidity information, are well placed to take advantage of the new investment world where liquidity is once again the result of market forces.

Conclusion

The world has changed in many ways over the past two to three years, and this has profound implications for asset managers. Strategies that worked in the easy money era may not be appropriate in the current environment. What investors now need are strategies that can adapt to changing market environments, take advantage of the higher volatility regime and incorporate disciplined risk management, robustness to market regimes and the ability to source scarce liquidity faster than their competitors. The new investment world is ideally suited to quantitative strategies that combine these characteristics in their investment approach.