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Corporate bond borrowing as proxy for short interest
Academic literature review
Recent performance update
Equity finance and short interest data are well known inputs for
quantitative models which seek for forecast equity returns. The
general concept is that equities with more short interest will
underperform those with less. Similar signals can be derived for
corporate bonds using the IHS Markit Securities Finance dataset for
corporate bond borrowing. In this note we'll review some academic
literature which supports this use case and discuss updated results including the
volatile period in 2020.
Background:
Using corporate bond borrowing as a proxy for short positioning
has been proposed by Hendershott et al (2018) in a
paper published in the
Journal of Financial and Quantitative Analysis. The authors
used the IHS Markit Securities Finance dataset to test the theory
that corporate bond short selling is a predictor of bond returns.
The results, drawn from a sample period from 2007 to 2011, suggest
that for high-yield corporate bonds there is a significant
correlation between bond price returns and the level of bond
borrowing.
There are multiple reasons to borrow and short a corporate bond,
which may range from a broker-dealer borrowing to deliver against a
long sale or a relative value trade between two bonds. The paper
noted above cites a previously published paper,
Asquith et al. (2013) using a single lender's dataset, which
suggests that corporate bond borrowing is a suitable proxy for
short positions in the bonds. More recent anecdotal evidence,
including correlations between bond borrow costs and CDS pricing,
reinforce that conclusion. An interesting agreement between the
papers is the observation that there did not appear to be signal
pre-GFC. While not every bond borrow equates to a directional short
bet in that bond, there is evidence to support the theory that the
signal is representative of short positioning in general.
Recent Results:
IHS Markit Securities Finance recently published updated
results, which show the performance of the bond short factor for
the iBoxx Global Developed Markets High-Yield Index. The key
finding in the updated results is that the results for high-yield
bonds highlighted in the academic research hold over the subsequent
decade, notably improving results during the Q1 2020 market
decline.
The most shorted HY bonds underperformed the least shorted by
19bps per month on average, from November 2009 through October 2020
(2.3% annualized). The existing index with the most shorted bonds,
underperformed the index excluding those bonds by 4bps per month on
average, or 48bps annualized.
Part of the relative underperformance by most shorted bonds was
driven by the Energy sector. Within HY Energy issuers, the most
shorted bonds underperformed by 66bps per month, a staggering 8.2%
annualized. The most shorted issues had a negative monthly return,
-26bps on average, during the 10Y+ observation period.
The relative underperformance of highly shorted HY Energy bonds
contributes to the index level result, however a crucial finding in
the updated research is that the index-level results do not rely
solely on the Energy sector. Removing the Energy constituents from
the backtest, the most shorted bonds underperform the least shorted
by 13bps per month, or 1.57% annualized. The most shorted ex-Energy
bonds underperform the full ex-Energy constituents by 2bps per
month, or 24bps annualized.
The underperformance of the most shorted HY bonds is
concentrated in the periods where the overall universe return was
negative. The 19bps average monthly underperformance of most
shorted bonds is the result of 187bps average underperformance in
the 47 months with a negative return for the total universe,
partially offset by the 75bps of relative outperformance on the
part of the most shorted bonds in the 84 months where the universe
return was positive. The takeaway is that the most shorted bonds
underperform by enough in the relatively few down markets that the
overall impact of removing them from the index is positive, even
though the most shorted outperform on average in the more frequent
periods where the universe has a positive return.
The Q1 2020 market decline provided an excellent test case for
the corporate bond short factor. The most shorted HY bonds returned
-16.6% in March 2020, while the least shorted returned -8.2%, a gap
of 8.4% in a single month. During the Q2 2020 HY recovery the most
shorted outperformed by 1.9% per month on average, culminating in
June when the most shorted returned 2.6%, while the least shorted
returned -0.5%. Overall, for the first three quarters of 2020 the
most shorted HY bonds underperformed the least shorted by 39bps per
month on average.
Conclusion:
With
increasing electronic trading of corporate bonds, the
possibility for systematic trading strategies is also increasing.
Corporate bond borrowing data provides an unparalleled insight into
short positioning at a security and issuer level. For high-yield
investors avoidance of credits with elevated short demand has
historically added to total returns. There is evidence to suggest
factor models for quantitative corporate bond investors may benefit
from incorporating bond borrowing signals. The results do not rely
on a particular sector, however the stark performance in the Energy
sector coinciding with the relative underperformance of the whole
sector suggests there may be also be a sector rotation use case for
systematic investment strategies. A key advantage compared with
relying solely on CDS data is the coverage, where bonds from nearly
all global issuers will be included in the securities finance
dataset, but not all will have CDS pricing. The results suggest the
IHS Markit Securities Finance dataset contains essential insights
for credit investors in 2021.
Posted 26 February 2021 by Sam Pierson, Director of Securities Finance, S&P Global Market Intelligence
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