Transaction Costs and Capacity of Systematic Corporate Bond Strategies

Abstract

Can systematic corporate bond investments generate attractive returns net of costs? To answer this question, we apply the principle of market microstructure invariance and obtain bond transaction costs increasing in trade size. As the size of the bond fund increases, the market impact reduces net returns 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. Transaction costs do not absorb the corporate bond risk premium even in the largest possible market portfolios.