This In Practice piece gives a practitioner’s perspective on the article “Factor Investing in the Corporate Bond Market,” by Patrick Houweling and Jeroen van Zundert, CFA, published in the Second Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
In equity markets, strategies based on value, small-capitalization, momentum, and low-volatility factors have been shown to produce superior long-term risk-adjusted returns compared with traditional cap-weighted indexes.
Factors are the broad and persistent return drivers of portfolios. Factor investing in equity markets has been shown to produce superior returns both individually and in combination. Factor investing in bond markets has been less researched, particularly regarding factors associated with value, size, momentum, and low risk constructed on the basis of bond characteristics. The authors investigate which individual bond factors carry the highest premiums and whether combining them in a multi-factor bond portfolio could provide additional benefits for investors.How Do the Authors Tackle the Issue?
The authors constructed factor portfolios by sorting a variety of corporate bonds according to four specific characteristics, or factors. These factors mirror factors used in equity investing. The authors define the four factors:
• Size: the bonds of small companies, based on the market value of their outstanding bonds
• Low risk: short-maturity bonds with a high credit rating
• Value: bonds whose credit spread is high relative to a model-implied fair spread
• Momentum: bonds with high past returns
In addition to assessing portfolios of individual factors, the authors created and analyzed a multi-factor portfolio combining the four factors.
To create the portfolios, the authors used data from the Barclays US Corporate Investment Grade Index and the Barclays US Corporate High Yield Index from January 1994 to June 2015, which resulted in more than 1.3 million bond-month observations. Bond returns were measured in excess of duration-matched US Treasury bonds.What Are the Findings?
Both single-factor and multi-factor portfolios generate economically meaningful and statistically significant alpha. That is, the portfolios produced excess returns compared with the benchmark bond indexes. By investing in factors rather than passively investing in the corporate bond market, index investors could triple their average excess returns, according to the authors.
The authors confirmed previous findings that the low-risk and momentum factors outperform in the bond universe. They also confirmed relatively new evidence of the outperformance of the value factor. The study provides evidence that the size factor in bond investing produces meaningful alpha.
Additionally, the four factors have relatively low correlations. Most paired correlations tend to be below 20%, except the correlation between value and size. The correlation is lowest between value and momentum. As a result, compared with the single-factor portfolios, the multi-factor portfolio substantially reduces tracking error and improves the information ratio, a measure of risk-adjusted return.
Furthermore, the four corporate bond factors were found to add value beyond their counterparts in the equity market. That is, by applying factor investing in the corporate bond market as well as in the equity market, investors can increase the alpha of their multi-asset portfolios by more than 1% per year.
What Are the Implications for Investors and Investment Professionals?
There are currently few investment vehicles for investors to harvest factor premiums in the corporate bond market. This contrasts with the equity markets, where value, small-cap, momentum, and low-volatility funds are widely available. This study provides investment managers and their clients with an opportunity to improve returns from their bond portfolios.
Multi-factor bond funds are something of a rarity, but the study appears to show they are worthy of investor consideration. The size of the premiums in the past may not be replicated in the future, so the best-performing factor in the past might not be the winning factor in the future. This argues for a multi-factor approach. The advantages for investors of allocating to multi-factor portfolios over selecting a single factor include the following:
• Diversifying across factors protects against the possible underperformance of one or more factors for prolonged periods of time.
• The tracking errors of individual factors in relation to the market are relatively large, but the tracking error of the multi-factor portfolio is well below the average of the tracking errors of the individual factors.
Implementation of bond factors in investment portfolios may not be simple, not least because of wide bid–offer spreads. Seemingly impressive reported alpha may be attributed to investing simply in bonds that are riskier than the benchmarked fixed-income vehicle. The authors account for an estimate of trading costs necessary to implement their strategy, but bond trading costs can be very high. Many external bond managers may be reluctant to implement factor investing because of the factors’ large tracking errors or low information ratios. The low-risk factor, for example, does not yield a high information ratio. Therefore, delegated and benchmarked asset management may, at best, lead to implicit and time-varying exposure to factors and, at worst, to no exposure at all.
Investors persuaded by the factor argument for their bond portfolios should, therefore, seek approaches that explicitly and consistently implement factor exposures in their investment strategies. In this way, say the authors, asset owners can “take back control” of their factor exposures from external managers and allocate to factors as directly as they can. This option will be available only to asset owners with the skills to create a suitable benchmark and measure returns against it.