Inflation drives the use of quantitative strategies

This year’s sharp rise in inflation has attracted more income-seeking fund managers to quantitative investment strategies in markets that track interest rate movements, a still-developing space – and , according to some, controversial – where banks are jostling for position.

Banks and investors have sought to develop the QIS in fixed income securities in recent years, as increased electronicization has made it easier to create strategies aimed at reaping returns systematically in these markets. This year’s unpredictable outlook for inflation and the central bank’s response have helped recruit more investors into rate-focused QIS as it has become more difficult to generate income from traditional bond portfolios. and shares.

In addition to trend-following strategies that seek to track changing dynamics in bonds and swaps, banks have tapped into the growing demand for derivative-based products that measure volatility in interest rate markets as prices have fallen this year. Bankers say some of these strategies have delivered impressive performance, while warning of the potential risks involved given the complexity of these markets.

“The development of QIS has always been very action-oriented. One of our priorities in recent years has been to develop bond strategies,” said Guillaume Arnaud, Head of QIS at Societe Generale. “It is more complex for banks to work out QIS rates. You need liquid instruments because you are committing to bidding and bidding for years to come, and you need a way to get objective external prices.

Fixed-income investors have been slower to embrace quantitative investing compared to the predominant role these strategies now play in equities, where hedge funds have been deploying technology to exploit market inefficiencies for decades. But electronicization has brought greater certainty of execution, price transparency and more data for companies to look into lucrative opportunities.

Valery Bloud, head of QIS client solutions at BNP Paribas, said fixed income securities have been the fastest growing area of ​​QIS in recent years, growing from around a quarter of the sector’s total assets there. is ten years old to more than a third today. This has happened even as broader QIS activity has grown significantly, growing about fourfold across the industry as a whole, he estimates.

Easy location

The backdrop of falling stock and bond prices this year has certainly not hurt the ground for quantitative strategies that aim to generate returns with low correlation to traditional assets.

Overall, QIS products have performed very well this year, said Pete Clarke, global head of derivatives strategy at UBS, whether it’s rates, equities, volatility or commodities. . This led to a “tremendous amount” of business in what he called “alternative carry” as well as defensive strategies and portfolios.

“We have seen many product developments in QIS rates as demand for alternative duration exposure has increased, with a wider range of clients in different geographies that we have added to the platform,” said said Tom Payne, EMEA head of structuring at UBS.

Government bond yields have tumbled this year as traders struggled to gauge inflation prospects. This has increased the appeal of dynamic strategies that can ride the swings in bond and derivative prices rather than having to bet on where returns will stabilize. Volatility-based strategies where investors buy and sell interest rate options have proven popular for similar reasons.

“Everyone is jumping on the QIS rate bandwagon, especially with what’s going on with inflation. The focus is on swaption indices and how banks offer rate volatility,” said Steve Loeys, head of index structuring at Nomura.

Trading Strategies

There are notable advantages to building quantitative strategies in swaption markets, where traders buy or sell the right to enter into an interest rate swap at some point in the future. These derivatives have a much longer maturity than listed derivatives and have many more benchmarks, providing financial engineers with a wealth of raw material to manufacture products. There are also favorable dynamics in these markets to explore.

In dollar swaptions, for example, callable debt sold to Taiwanese insurers (Formosa bonds) depresses long-term volatility, creating a downward-sloping swaption curve. This dynamic, known as backtracking, makes it easier to create strategies aimed at producing regular returns for the investor, while retaining certain defensive qualities that seek to protect against a sudden jump in volatility.

“Defensive carry has been popular in these markets given the lack of conviction about the direction of bond yields,” BNPP’s Bloud said. “The shape of the interest rate option futures curve can give the investor positive carry, while long exposure to volatility helps if markets turn fragile.”

But these strategies can be problematic, say some bankers. Swaption markets are nowhere near as liquid or transparent as listed stocks or futures, making it difficult to provide an accurate (and objective) valuation of positions, especially after the first day of trading when options are no longer at par. Some also criticize the way strategies are sometimes developed in this space.

“Many strategies are highly parameterized to produce good backtests,” said Kirt Bains, head of marketing and index creation at Nomura. “We don’t believe it: there is no free lunch.”

Exposure volume

Tony Morris, who runs QIS at the Japanese bank, said it was important to understand where returns come from on products such as so-called swaption triangles – a popular three-legged structure giving investors exposure to different parts of the volatility surface.

“It’s usually because they contain a cargo of short gamma [exposure to short-dated volatility]”, Morris said. “The downward sloping nature of the flight surface is a great story, but it doesn’t stand up to scrutiny. of volatility.

Arnaud de SG said the short gamma exposure was akin to a financing leg of the deal. “It can cost you money in specific scenarios, but it can add value over time,” he said.

It’s important to make sure the client is still long “vega” (longer-term volatility) so they have positive exposure to rate volatility, he said, while the negative impact of the gamma leg can be reduced if the client accepts a lower return. profile. A short term trend following component can also be added to provide hedging.

“We’re seeing customers doing this more and more over the past few months, becoming more explicitly defensive,” Arnaud said.

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