CHAPTER 1
Setting the Stage

OVERVIEW

This chapter defines key terms that will be used throughout the book. I start by describing fixed income securities and the size of the global fixed income markets. I introduce the term systematic and distinguish it from quantitative. All fixed income market participants are quantitatively aware; after all commonly used analytics like duration and convexity require a little more than elementary school mathematics. However, not all fixed income investors are systematic in how they translate their investment narratives into portfolios. That is what it means to be a systematic investor: prespecifying your investment hypotheses (narrative) and then converting that to an algorithm that generates trades and ultimate portfolio positions. We will explore the key ingredients of that algorithm as we proceed through the book. Finally, while this book is designed for fixed income investors and not financial engineers, resulting in minimal mathematical proofs, it is still important that commonly used analytics like yields, durations, and convexity are well understood. We will cover the intuition of these concepts, and their limitations, in detail.

1.1 WHAT IS FIXED INCOME?

This book is focused on understanding the investment opportunities available to asset owners from the fixed income markets. We need to define what makes a financial asset a fixed income security. But let's first start with a brief discussion of what a financial asset is to help set the stage for what is to come later in this chapter. All financial assets provide the owner a right to share in the cash flows generated from ownership. The price of a financial asset today will reflect expected cash flows for today, tomorrow, and all future time periods until the security ceases to exist. You don't need to hold the security to maturity to receive the actual cash flows: the price of the security will capture expectations (albeit noisily) of all future cash flows. Implicit in this last statement is an equivalence of cash flows that accrue over different time periods. Of course, there is a complicated discounting that is applied to expected future cash flows to arrive at a price. These statements are true for all financial assets, whether they be common stocks or bonds or any other contractual claim.

We can start with a simple general equation linking the price of a financial asset to its expected cash flow participation rights:

Equation 1.1 is a discrete time pricing formula generalizable to all financial assets. E[] captures expectations based on information today with respect to future cash flows, CF. These cash flows are discounted back to today, reflecting not just time value of money considerations but also perceived risk of associated cash flows. (We will have more to say on discount rates and its components throughout this book.) Fixed income securities are relatively unique, relative to equity securities, in two key respects. The key is in the name of the asset class: "fixed" income. First, the numerator is less important from a security valuation perspective (cash flows are "fixed"). Expected future cash flows for fixed income securities (the numerator) are typically known in advance, with almost complete certainty for truly risk-free securities. Uncertainty in the numerator (one-sided for fixed income and more two-sided for equity) is increasing in the risk that the issuer will be unable to deliver those future cash flows (e.g., a risky corporate issuer). Generally, fixed income security pricing is dominated by the denominator. In contrast, equity securities require detailed forecasting of both the numerator and denominator for any meaningful security valuation. Some might be tempted to say fixed income investing is easier as a result. Alas, it is not; it is just that your focus is shifted to the denominator. Second, fixed income securities have limited lives, and the life of the fixed income security is typically also "fixed." Of course, there are complexities with embedded options that can alter (usually shorten) the life of a fixed income security, but fixed income securities generally have a prespecified time to pay cash flows. This has very important implications for valuation of the cash flows. As time passes the value of the claim will change, absent any changing views of the expected cash flows. This gives rise to unique investment opportunities and challenges for fixed income securities (e.g., the importance of carry for identifying expected returns and the complications of modeling the deterministic time-varying risk profile of fixed income securities), all of which we will cover in detail later in this book.

So where do the fixed income securities come from? Entities of various forms require capital to finance their operating and investing activities. The most common entities that issue fixed income securities are (i) governments and quasi-government entities, and (ii) corporations. We will focus on fixed income securities from these two issuers in this book. Governments and corporations from all countries engage in debt financing across both developed and emerging markets. Our focus will be on developed markets, but there will be some discussion of the unique risks and investment opportunities in emerging market debt in Chapter 7. There is also a large set of asset-backed fixed income securities. These are largely repackaging of other fixed income securities into pools where the cash flow rights are reassigned to new fixed income securities. Perhaps the largest securitized market is the government sponsored mortgage-backed securities in the United States. But there are other large pools of securitized assets globally such as covered bonds issued by financial institutions (largely in Europe) and nonagency mortgages. We will have less to say on securitized assets in this book, outside of the prepayment risk premium to be discussed in Chapter 2. However, the security valuation frameworks and portfolio construction considerations we cover for the more common government and corporate fixed income securities can be tailored across the full breadth of fixed income securities.

1.2 HOW BIG ARE FIXED INCOME MARKETS?

Let's start broad when assessing the size of the potential investment opportunity set for the fixed income asset class. Although there are no universally accepted statistics for the true size of fixed income (or indeed equity) markets, the Bank for International Settlements is a commonly used reference for this purpose. Exhibit 1.1 shows the size of global fixed income markets as of December 31, 2020. Clearly, the global fixed income market is enormous, accounting for a little over $123 trillion USD. This estimate is an attempt to capture broadly investible fixed income markets. Ilmanen (2022) notes that the size of global fixed income markets could be closer to $200 trillion if all money market securities and all bank loans were included. Global equity markets, in contrast, were valued at $106 trillion USD as of December 31, 2020.1 There is clearly a concentration in debt securities in developed markets, but there is an increasing presence of Chinese domiciled issuers over the past decade.

An alternative way to understand global fixed income markets is to assess the relative importance of issuer type. Exhibit 1.2 shows that government entities (includes supranationals and quasi-sovereign issuers) account for a little more than half of total fixed income securities outstanding. Financial institutions (inclusive of asset-backed securities and regular bonds) account for around a third of global fixed income securities, and nonfinancial corporations account for the remainder. This explains our focus on government and corporate fixed income securities, as these account for most global fixed income securities.

EXHIBIT 1.1 Market capitalization of global fixed income markets as of December 31, 2020. All securities are valued in USD. Fixed income securities are grouped into countries based on the domicile of the issuer and are dependent on source data availability at the country level.

Source: Data from Bank for International Settlements (www.bis.org/statistics).

The debt securities included in Exhibits 1.1 and 1.2 include domestic debt securities (DDSs) and international debt securities (IDSs). The Bank for International Settlements (BIS) defines DDS as those instruments issued in the local market of the country where the borrower resides, regardless of the currency in which the security is denominated, and IDSs as those instruments outside the local market of the country where the borrower resides. Approximately 80 (20) percent of fixed income securities are DDSs (IDSs) as of December 31, 2020. Correspondingly, our focus will be on domestic fixed income securities, as this reflects the bulk of the fixed income investment opportunity set. This is not to say that international securities are not relevant. They are, and in Chapter 7 we will discuss hard currency emerging market debt specifically. It is important to remember that although the issuance of debt securities by an issuer in multiple countries (and multiple currencies) does expand the investment opportunity set, these additional securities, while not totally redundant, are usually highly correlated with the domestic security.

EXHIBIT 1.2 Market capitalization of global...