Transaction costs and capacity of systematic corporate bond strategies

Can systematic corporate bond investments generate attractive returns net of costs? To answer this question we apply a methodology that allows us to estimate both implicit and explicit transaction costs and thus capacity constraints in systematic long-only bond strategies. The methodology is based on Kyle and Obizhaeva (2016)'s principle of market microstructure invariance and implies bond transaction cost functions with positive market impact estimates which is in contrast to prevailing transaction-based approaches. As the size of the bond fund increases, the market impact reduces net returns down to zero. High-turnover strategies hit capacity constraints fast. Low-turnover credit-risk-focused strategies have much higher capacities that can be further increased by constraining portfolio rebalancing in realistic ways. We find that transaction costs do not absorb the corporate bond risk premium even in the largest possible market portfolios.