Guest post by Stephen DiTursi, CEO & Senior Portfolio Manager, One Oak Capital Management
Today, being bigger is not necessarily better when focusing on investment grade corporate bond management, especially if you are expected to outperform the familiar bond indices. Being nimble, with a short-term focus combined with a small footprint can allow you to convert trading opportunities into significant alpha for investors.
While this phenomenon has been true in many illiquid asset classes, it has become particularly prevalent in the investment grade corporate bond market over the past 10 years. The major reason is simple; market size has exploded, while dealer capital and participants have shrunk dramatically. Combining this with the significant consolidation of active fixed income managers and the advent of passive debt and ETFs results in a herd mentality where targeted opportunities are often ignored.
Opportunities in investment grade corporate bonds exist across the marketplace daily, and can be exploited, by smaller managers, especially during periods of reduced liquidity. Being nimble allows them to move in and out of positions quickly to extract alpha. This rapid movement from opportunity to opportunity, or velocity, enables the managers to turn small short-term trading gains into significant profits over longer periods.
Unlike traditional buy-and-hold strategies, short-term trading strategies benefit from the growth of electronic trading due to:
- Extremely high concentration of overall assets with the largest managers. Their need to deploy large capital balances reduces the viability of investing in small trading opportunities.
- Less overall capital readily available for active trading opportunities
- More passive money in the hands of a very few.
- Shrinking capital at dealer/proprietary trading desks due to the Volker Rule and Basel III.
- Declining number of broker dealers, leaving mostly large entities focusing on only the largest clients.
- More “asset liability matching” strategies among corporate bond managers who oversee tax-exempt corporate pension plans and insurance companies.
- Mutual funds seeking to avoid negative tax events (short-term trading gains) on their corporate bonds positions.
- Managers focusing on yield rather than total return.
- A heavy issuance calendar.
All of this has magnified the herd mentality in the investment grade corporate bond market. The competition for liquidity ebbs and flows over the long term, but can become extreme even during relatively minor macro events as bond sellers rush to the exits at the same time.
Generating Alpha While Providing Liquidity
This situation presents a huge value-added opportunity for a nimble manager with the trading acumen to find opportunities and sophisticated risk management tools to manage risks effectively.
Corporate bond managers are not all the same. The majority have asset/liability management backgrounds are not skilled in identifying short-term mispricing or supply/demand imbalances. Their skills are much more attuned to finding undervalued credits over longer time horizons, and they tend to focus on coupon versus total return. As the proprietary dealer trading desks shrink in size and number, true trading ability is becoming a thing of the past.
Skilled traders, with their nimble strategies, both in terms of size and ability to allocate capital, can deliver deep value and provide liquidity to the marketplace while generating uncorrelated returns for their investors.
Trading oriented managers who combine their opportunistic approaches with well-executed security and portfolio hedging techniques to minimize extraneous credit and rate effects stand to benefit even more, as they can capture while minimizing yield and credit beta.
Despite the advent of electronic trading, One Oak continues to see significantly more “alpha opportunities” available than there is capital to exploit them. Major drivers to these opportunities are market volatility and trading “velocity”, or turnover. The first is market volatility, which is a key factor in generating attractive opportunities. The higher the volatility, the more opportunities arise, driving our strategy’s overall level of returns. Volatility usually arises when there is investor uncertainty, which is when most fixed income strategies tend to underperform. For One Oak, the herd mentality mentioned earlier on exacerbates the mispricing resulting from emotional trading decisions. As a result, more opportunities tend to surface, leading to more turnover, which can lead to higher returns. In summary, we believe the structure of the investment grade corporate bond market in the US, and even globally, continues to foster the creation and existence of short-term trading opportunities.
This paper is for informational purposes only and is not an offer to sell or the solicitation of an offer to purchase an interest in any of the funds managed by One Oak Capital Management. This information should be considered and treated as confidential and no information contained herein either in whole or in part may be reproduced or redistributed without One Oak’s express written consent. Although information and analysis contained herein has been obtained from sources One Oak Capital Management believes to be reliable, its accuracy and completeness cannot be guaranteed. Although we believe this data source to be accurate, we make no guarantee as to the actual accuracy of the data. The returns do not include other expenses which may impact performance. Actual fees vary among clients. This report is for informational purposes only and is not an offer to sell or the solicitation of an offer to purchase an interest in any of the funds managed by One Oak Capital Management.