Systematic credit investing has become increasingly popular in recent years as investors look for ways to generate consistent returns and manage risk. A systematic approach utilizes quantitative models and rules-based processes to make investment decisions, rather than relying solely on qualitative analysis or individual security selection. This methodical strategy aims to capitalize on inefficiencies in the credit markets in a disciplined manner. One example of systematic credit investing is to screen the investment universe based on fundamental credit metrics, identify relatively undervalued securities, and tilt the portfolio towards higher yielding credits while controlling for risk factors. This article will provide an overview of systematic credit investing and discuss the potential benefits and challenges of this approach.
Screening the investment universe is a key first step
The starting point for many systematic credit strategies is screening the overall investment universe, which can include corporate bonds, loans, structured products and other fixed income assets. The screening process will filter the universe based on criteria such as credit ratings, sector exposures, duration, liquidity, issue size and other characteristics. For example, a portfolio manager may screen for BB-rated corporate bonds with 5-7 year durations and at least $500 million in issue size. This helps focus the opportunity set and eliminate less attractive or higher risk securities upfront before further analysis.
Fundamental credit metrics help identify undervalued bonds
After screening, the next step is analyzing the fundamentals of the issuers and securities that remain in the focused universe. Systematic managers will examine financial ratios like leverage, interest coverage, profitability, cash flow and more. The goal is to identify bonds that appear underpriced relative to their underlying credit risk. For instance, a BB-rated issuer with very strong interest coverage and low leverage may be providing too much credit spread compensation based on its actual default risk. A model can signal that this bond is relatively undervalued.
Portfolio construction incorporates risk controls
With a subset of securities flagged as having attractive valuations, the portfolio is then constructed by weighting individual positions to balance risk and return. Limits are typically imposed on sector, industry, issuer and other exposures to prevent concentration risks. Duration targets will also be set to manage interest rate sensitivity. An optimization process determines the weightings across securities to maximize expected return for the targeted risk level. As the market evolves, the portfolio is rebalanced periodically to maintain the systematic rules and risk controls.
Potential benefits include consistency, diversification and lower costs
Systematic credit investing offers several potential advantages compared to traditional active management approaches. The rules-based process aims to provide more consistent returns over time by eliminating individual manager biases and inconsistencies. The diversified portfolios also help manage risks across credit sectors, regions and issuers. In addition, the scale and efficiency of quantitative models can translate into lower management fees compared to traditional credit strategies that are more labor intensive.
In summary, systematic credit investing relies on quantitative models to screen, analyze, select and weight fixed income securities in a disciplined process. This methodical approach seeks to provide efficient exposure to credit risk premiums while controlling portfolio risks. As credit markets continue to grow in size and complexity, systematic strategies are likely to play an increasingly important role for many fixed income investors.