Setting the Stage for Fixed Income Investing: What Every Investor Should Know
Previous: Introduction to the Series
Before we get into the weeds of bond investing, we need to agree on some basics. What even is a bond? How big is this market? And what does “systematic” mean when people throw that word around?
Chapter 1 of Systematic Fixed Income by Scott Richardson lays out exactly that. It is the foundation for everything that comes later in the book. So let us walk through it.
What Is a Fixed Income Security?
Every financial asset gives you a claim on future cash flows. You buy something today, and in return, you get money later. The price you pay reflects what those future cash flows are worth right now.
Stocks work this way. Bonds work this way. Pretty much everything in finance works this way.
The difference with bonds is right there in the name: “fixed” income. The cash flows are mostly known in advance. You know the coupon payments. You know when you get your principal back. There is not a lot of guessing about the numerator (the cash flows themselves).
With stocks, you have to forecast both the cash flows AND the discount rate. With bonds, the cash flows are largely set in stone. So all the action happens in the denominator, which is the discount rate.
Some people think that makes bonds boring or easy. Richardson says no. It just means the hard work shifts to understanding interest rates and spreads. Different challenge, same difficulty.
Bonds also have a fixed life. They mature. This creates interesting dynamics because even if nothing changes about the market, the value of a bond shifts as time passes. That is a big deal for how you think about returns.
Where Do Bonds Come From?
Governments and corporations need money. They borrow it by issuing bonds.
Government bonds are the backbone of the fixed income market. These range from US Treasuries to Japanese government bonds to debt from emerging market countries. Corporate bonds come from companies that need financing for operations, expansion, or acquisitions.
There is also a massive market for securitized assets. Think mortgage-backed securities, covered bonds, and other packaged debt. But the book focuses mostly on government and corporate bonds since they make up the bulk of what investors deal with.
How Big Is This Market?
Big. Really big.
As of December 2020, global fixed income markets were worth about $123 trillion. For context, global stock markets were valued at $106 trillion at the same time. Bonds are actually the bigger market.
If you include all money market securities and bank loans, the number could be closer to $200 trillion.
The Bloomberg Global Aggregate Index, which is a commonly used benchmark for large institutional investors, held 26,514 individual bonds worth $67.5 trillion. That breaks down roughly like this:
- Government bonds (Treasury): $35.9 trillion
- Corporate bonds: $12.7 trillion
- Government-related entities: $10.0 trillion
- Securitized debt: $8.9 trillion
Here is something interesting. Government bonds are fewer in number but each one is massive in value. Corporate bonds are the opposite: there are thousands of them, but each individual bond is relatively small. That creates real liquidity challenges for corporate bonds, and it is a theme that comes up again and again in this book.
Speaking of liquidity, there are roughly seven bonds outstanding for each investment-grade corporate issuer. That sounds like variety, but it actually creates fragmentation. Too many bonds chasing too little trading volume. A handful of bonds (maybe two or three) can capture most of the return variation for a given issuer. The rest are just noise adding complexity.
What Does “Systematic” Actually Mean?
This is where things get interesting. Richardson draws a clear line between “quantitative” and “systematic,” and they are not the same thing.
Every bond investor is quantitative to some degree. You have to be. Duration, convexity, yield calculations… these all require math. Knowing how to compute them does not make you systematic.
Being systematic means you prespecify your investment ideas and convert them into a repeatable algorithm that generates trades. You write down your rules before you look at the data. Then you let the process run.
A discretionary manager, by contrast, relies on an individual’s judgment, storytelling, and gut. They have a narrative. They see something in the market and act on it. Both approaches share similar core beliefs about what drives returns. The difference is in how they implement those beliefs.
Richardson shares a great anecdote. He once gave a presentation to a large sovereign wealth fund, right after a traditional discretionary manager. The head of the internal team told him: “You sound very similar to the traditional manager, yet your final portfolios are quite different.”
Same ideas. Different execution. That is the gap between systematic and discretionary.
The systematic approach does not lean on any single star portfolio manager. Trade lists come from the process, not from a person’s conviction on a given morning. Humans still review the output. If overnight news breaks that changes the picture for a specific bond, someone steps in. But the default is process over personality.
Richardson outlines five ingredients for building a systematic investment approach:
- Credible hypothesis. Does your idea pass a sniff test? Why would this work?
- Robust predictive power. Test the idea across multiple markets and time periods.
- Test the mechanism. Go beyond return correlations. Can your signal forecast fundamentals?
- Implementation. Does the idea survive transaction costs and real-world trading constraints?
- Additivity. Is the idea adding something new to the portfolio, or is it redundant?
As of 2020, systematic fixed income investing was still tiny. About $120 billion in assets, which is nothing compared to the $123 trillion market. But that number had been growing fast, adding $50 billion in just five years.
Yields, Duration, and Convexity
These three concepts are the language of bond investing. You need them to have any conversation about fixed income.
Yield is basically the discount rate for a bond. It tells you the return you would earn if you bought the bond today and held it to maturity (assuming no defaults and that you reinvest coupons at the same rate). Yields across the Global Aggregate Index have been falling for decades. By late 2020, about 4,251 bonds in the index (worth $16.1 trillion) traded at negative yields. Government bonds in late 2020 were at the lowest yields in over 700 years of recorded history. That is not an exaggeration.
Duration measures how sensitive a bond’s price is to changes in interest rates. A bond with a duration of 9 years will lose about 9% of its value if rates go up by 1%. Longer maturity and lower coupons both push duration higher. A zero-coupon bond has duration equal to its maturity, which is the maximum.
Duration works well for small changes in rates. For bigger moves, you need the second piece.
Convexity captures the curvature in the relationship between bond prices and yields. Duration gives you a straight-line approximation. Convexity accounts for the fact that the actual relationship is curved. For most government and corporate bonds, convexity is not a huge factor. But for mortgage-backed securities and bonds with embedded options, it matters a lot.
One more wrinkle. There are actually two types of duration. Effective duration measures sensitivity to changes in risk-free interest rates. Spread duration measures sensitivity to changes in credit spreads. Both matter, and they capture different risks.
Over the past two decades, the duration of the Global Aggregate Index has been creeping higher. Issuers have been selling longer-dated bonds because rates are low. Combined with those low rates (which mechanically increase duration), this means bond portfolios have become more sensitive to rate changes over time.
Currency, Home Bias, and Active Share
Richardson wraps up the chapter with three practical considerations.
Currency hedging is important because currency movements can dominate bond returns. The book takes the position that you should hedge your currency exposure. That way, your bond bets are about bonds, not about guessing where the dollar or euro is headed.
Home bias is widespread and a bit puzzling. About 96% of funds benchmarked to the US Aggregate Index are domiciled in the United States. That is a lot of eggs in one basket. There are legitimate reasons for it (liability matching, economic hedging), but the extent of the bias means investors are leaving international diversification on the table.
Active Share, which measures how different a portfolio is from its benchmark, does not translate well to bonds. A corporate bond ETF might hold only half the bonds in its index and still track the index closely. That is because many corporate bonds from the same issuer are near-perfect substitutes. Counting portfolio differences without considering the risk overlap is naive. Tracking error is a better metric.
The Bottom Line
Chapter 1 is about getting everyone on the same page. Bonds are a massive, complex market. Systematic investing is a disciplined, process-driven approach to navigating that market. And the basic tools of the trade, yields, duration, and convexity, are not hard to understand conceptually even if the math can get deep.
The key takeaway is that systematic and discretionary investors mostly agree on what drives bond returns. They just disagree on how to act on those beliefs. That difference, process versus personality, is what the rest of this book explores.
Next: Fixed Income and Strategic Asset Allocation
Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. ISBN: 9781119900139 Publisher: John Wiley & Sons, 2022