Digging more into fixed income factors

Matt explains how to incorporate factor-based insights into a bond portfolio.

A few months ago my colleague Sara Shores and I discussed factor investing and smart beta and what they mean for fixed income markets. Our conversation took us through the different types of factors: macro factors that drive the level of returns for asset classes, and style factors that drive the differences in return among individual securities within an asset class. We focused on the two dominant macro factors—credit risk and interest rate risk—and how holding these factors together provided diversification benefits because of their historically low to negative correlation. One way to create a factor-based fixed income strategy is by balancing credit and rate risk. In short, using factor-based insights can help build better fixed income portfolios.

Today I wanted to dig deeper into style factors and answer some questions that have come up from investors on this fast growing segment of the bond market. Factor investing is a way for investors to try to capitalize on a market anomaly or capture a risk premium. Style factors—namely value, quality, momentum and size—are factors that most investors are familiar with from the equity market. When looking at fixed income markets, we have found that these style factor opportunities are sometimes less obvious and harder to capture.

For example, trading securities in fixed income markets typically incurs much higher transaction costs than equity markets. This makes factor approaches that rely on high portfolio turnover, such as momentum, very difficult to implement. The factors that we have found to make more sense are value and quality, especially when they are combined into a single strategy.

Why factors work in fixed income

The most often asked question I get is: Why does factor investing work in fixed income? What anomaly or risk premium does it capture?

Many investors look to their bond portfolio as a source of income, and therefore favor higher yielding securities. But this can drive the prices of these bonds up, making them expensive relative to lower yielding securities. BlackRock research shows that this phenomenon has occurred specifically within certain groups of corporate bonds that carry similar credit ratings. Higher risk bonds have had their prices bid up, and as a result they do not provide investors with as much yield as would be expected. This is just one example of a fixed income market anomaly that a factor-based portfolio could be built around.

Quality and value, together

Questions have also come up around quality and value. Why are these factors often paired together? Why doesn’t quality or value work as a stand-alone strategy in fixed income, when it’s fairly common in equities? It turns out that these factors by themselves can lead to suboptimal outcomes in fixed income portfolios.

Take quality for example. Screening on quality can create a portfolio of securities that is generally lower in risk than the broad market, and also lower in yield. The quality portfolio may have higher risk-adjusted returns than the broad market, but it will also likely have lower overall returns due to the lower yield. This tradeoff may not be appealing to some investors—the improvement in risk-adjusted returns may not be worth the cost of giving up total return.

With the value factor, we see almost the reverse dynamic at play. Tilting toward value can create a portfolio of high yielding securities relative to the broad market. However, these higher yielding bonds are often the most risky, resulting in a lower risk-adjusted return than the broad market. The value portfolio could generate higher returns and yields but not without the cost of higher risk. This may not be palatable to fixed income investors, especially those who rely on their bond portfolio as a source of relative safety and stability.

Combining quality and value is thus intuitive. Applying a quality screen to the market can remove those securities with the highest expected chance of defaulting, resulting in a higher quality universe of securities from which to build a portfolio. Bonds are then chosen using a value tilt, picking the higher value names after the worst have been removed. Stepping back from the world of factors for a minute, this strikes me as a practical way of building a bond portfolio. First, remove all the bonds that have a higher chance of defaulting. Then, build a portfolio from the higher valued bonds left over. This process is similar to the approach that many active mutual fund managers take with credit research on corporate bonds. The factor-based approach puts similar insights to action but in a systematic manner.

Style factor indexes

BlackRock recently introduced two new style factor indexes: the BlackRock Investment Grade Enhanced Bond Index and BlackRock High Yield Defensive Bond Index. Both are constructed using quality and value factor insights. The indexes have only been live for about four months, but we have made historical performance information available. It is early days, but the growth of factor investing should provide some new and interesting opportunities for investors.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

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