Transaction costs and capacity of systematic corporate bond strategies


Recent scientific advances in return predictability and competitive pressures have led to a growing interest in systematic strategies and factor investing in corporate bonds in academia and industry. In this paper, we employ a recently developed methodology to estimate transaction costs and capacity constraints in systematic corporate bond strategies. We apply principles of market microstructure invariance to evaluate corporate bond transaction costs. Unlike prevailing transaction-based estimates of bond trading costs, pricing functions implied by microstructure invariance have a positive market impact. As the size of the bond fund increases, the market impact part of transaction costs drives net return down to zero. We find that high-turnover strategies that exploit reversal and illiquidity signals reach capacity fast. Low-turnover strategies targeting credit risk premia have capacities up to twenty times higher than high-turnover strategies. The capacity can be increased considerably by placing restrictions on portfolio rebalancing. We also find that the corporate bond market risk premia are not absorbed by transaction costs even in the largest possible market portfolios.