Execution Strategies in Fixed Income Markets

Reducing trading costs and slippage is a universal concern of asset managers. Although the decision of what assets to hold is stil the most important aspect of investing, poor execution of trade decisions can subtract many basis points from overall return. Conversely, having an effective strategy to execute trades and to measure transaction costs can enhance returns: “A penny saved in slippage is a penny earned in alpha.” Execution techniques in equities have advanced far ahead of those in other markets such as futures, options, foreign exchange, and fixed income. One reason for this is the overall size of the equity markets, and the widespread use of active investment strategies. A second reason is the simplicity of the products themselves: for trading a single name of stock you need very little information beyond its price. Relationships between different stocks are at best weak. As a consequence, quant researchers in equity markets have focused intensively on the details of the execution process. By contrast, fixed income products are inherently complex, and quantitatively minded researchers in the area have focused on such aspects as yield curve modeling, day counts, etc. Asset managers have not traditionally focused on measuring or managing execution costs, and have few effective tools to do so. However, the Securities Industry and Financial Markets Association (SIFMA) in 2008 (SIFMA Asset Management Group, 2008) noted that “It is clear that the duty to seek best execution imposed on an asset manager is the same regardless of whether the manager is undertaking equity or fixed-income transactions.” This chapter discusses some details of the fixed income markets that present special challenges for best execution in general and automated trading in particular. The focus will be on interest rate mar-