Setting the Stage: What Fixed Income Is and Why It Matters
Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. Publisher: John Wiley & Sons, 2022 ISBN: 9781119900139
Before we get into the fancy stuff, we need to understand the basics. Chapter 1 of Richardson’s book does exactly that. It defines the key terms, shows how big the market is, and explains what it actually means to be a “systematic” investor. Let’s break it down.
What makes a bond a bond?
Every financial asset gives you a right to share in future cash flows. Stocks give you a claim on a company’s profits. Bonds give you a claim on fixed payments.
The word “fixed” is doing a lot of work here. With a bond, the cash flows you expect to receive are mostly known in advance. A government bond will pay you specific coupon payments on specific dates, then return your principal at maturity. No guessing needed.
This means bond pricing is mostly about the denominator. The discount rate. When you buy a stock, you need to forecast both future earnings (the numerator) and the appropriate discount rate (the denominator). With bonds, the numerator is basically given to you. Your entire focus shifts to what discount rate the market applies to those known cash flows.
The other key feature: bonds have limited lives. A 10-year bond matures in 10 years. As time passes, the bond’s characteristics change automatically. This creates unique investment opportunities and challenges that do not exist in equities.
How big is this market?
Big. Really big.
As of the end of 2020, global fixed income markets totaled about $123 trillion. Some estimates put it closer to $200 trillion when you include money markets and bank loans. For context, global equity markets were valued at about $106 trillion at the same time.
Government entities issue a little more than half of all bonds. Financial institutions (including asset-backed securities) account for about a third. Nonfinancial corporations make up the rest.
The Bloomberg Global Aggregate Index, a common benchmark for institutional investors, contained 26,514 individual bonds worth $67.5 trillion as of the end of 2020. That breaks down into roughly $36 trillion in government bonds, $10 trillion from government-related entities, $13 trillion from corporations, and $9 trillion in securitized debt (mostly mortgage-backed securities).
Here is something interesting about bond markets compared to stocks. A single government like the United States might have 267 bonds outstanding. A typical investment-grade company has about seven bonds. This creates a liquidity problem. When you have many slightly different securities from the same issuer, trading gets spread thin across all of them. Most of the return variation across bonds from the same issuer is shared, so investors are basically splitting their liquidity across redundant securities.
What does “systematic” actually mean?
This is where Richardson draws an important distinction. Being quantitative and being systematic are not the same thing. Every bond investor needs to understand duration and convexity. That is quantitative. But not every bond investor follows a systematic process.
A systematic investor prespecifies their investment hypotheses and converts them into an algorithm that generates trades. A discretionary investor relies on individual judgment and narratives to make trading decisions day to day.
Here is the thing. Both approaches share a lot of common ground. They both need to understand yields and spreads. They both believe markets are not perfectly efficient. They both think they can add value through active management.
The difference is in execution. A systematic process does not rely on any one person making daily decisions. Trade lists come from the model. Humans check the output for data integrity and unmodeled risks, but the core process is repeatable and scalable. A discretionary process leans heavily on the lead portfolio manager’s judgment.
The result? Systematic portfolios tend to be more diversified, with more positions and lower tracking error. Discretionary portfolios tend to be more concentrated, with fewer positions and higher tracking error. Neither approach is clearly better in terms of risk-adjusted returns. They just get there differently.
Richardson outlines a recipe for systematic investing that comes from his days at Barclays Global Investors: start with a credible hypothesis, test it robustly across markets and time periods, validate the economic mechanism behind it, make sure it survives implementation costs, and confirm it adds something new to your portfolio.
Yields, duration, and convexity
Bond investors talk in yields. The yield is basically the discount rate that makes the present value of all future cash flows equal to the current price. Think of it as the expected return you will get if you buy the bond and hold it to maturity (assuming no defaults and you reinvest coupons at the same rate).
Yields have been on a long downward trend. Richardson shows data going back to the 1300s, and current government bond yields are at or near the lowest levels in seven centuries. As of the end of 2020, over 4,200 bonds in the Bloomberg Global Aggregate traded at negative yields, collectively worth $16 trillion.
Duration tells you how sensitive a bond’s price is to changes in yields. For a simple example, a 10-year government bond with a 2% coupon has a duration of about 9.16 years. That means a 1% rise in yields would cause the price to drop by roughly 9.16%.
Duration is a first-order approximation. It works great for small yield changes. For larger moves, you need convexity, which is the second-order effect. Think of duration as the slope of the price-yield curve, and convexity as the curvature. For most government and corporate bonds, duration alone gets you pretty close. Convexity matters more for bonds with embedded options, like mortgage-backed securities.
One important detail: there are multiple types of duration. Effective duration measures sensitivity to risk-free interest rates. Spread duration measures sensitivity to credit spreads. A corporate bond has both. And because yields have a term structure (different rates for different maturities), you can slice duration into key rate durations at various points along the curve.
Duration has been increasing over time. Issuers have been selling longer-dated bonds to lock in low rates, and lower yields mechanically increase duration. This means that any given change in interest rates now has a bigger impact on bond prices than it would have a decade ago.
The bottom line
Fixed income is a massive, complex market where the main game is understanding discount rates. Systematic approaches are still relatively rare in this space, with only about $120 billion managed systematically versus the $100+ trillion market. That gap represents both a challenge and an opportunity for investors willing to build the infrastructure to do it right.
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