Morgan Stanley IM: The MSIM Quantitative Credit Strategy Model

Our proprietary MSIM Quantitative Credit Strategy (QCS) model advises us on tactical investing in credit markets over a relatively short time horizon (around 1 month). The model is based on five factors:

1. Momentum
2. Risk Sentiment
3. Carry
4. Valuation
5. Business Cycle

Individually, each of these factors has limited power in predicting short-term credit excess returns, but when combined they create a more successful and reliable signal. This makes intuitive sense: by looking at a broader range of information, one gets a better picture of the appropriate risk to take.

Our back-tests show generally attractive Information Ratios, strong performances during periods of market stress and few significant drawdowns (before taking transaction costs into account). However, they also have modest returns for extended periods, so should not be relied on to generate attractive returns in all market conditions.

In all, our QCS is an important part our investment process, but only one of several inputs we consider.

Introduction

The fundamental characteristic of credit investing is that lenders are paid a higher interest rate than the default-risk-free rate as compensation for the risk that creditors do not pay them back in full and/or on time. Historical data for the largest and most established corporate credit markets (e.g. the U.S. investment grade (IG) corporate market) show that this additional return has more than compensated investors for realised default losses, suggesting that a portion of the additional yield pick-up, or credit spread, reflects credit risk premium rather than actual default expectations.

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