Factor investing, which has been around for quite some time in equity markets (and has taken over the world of equities) is migrating these days to the fixed-income arena. This one, targeting certain drivers of returns known as “Factors”, offers a bounty to harvest but also presents several unique challenges in the fixed-income space. In this Insight, we examine the historical evidence and outline the factors that drive returns in fixed income.
Understanding Factor Investing in Fixed Income
At the heart of factor investing lies a belief that specific features, or factors as they are known in investment jargon can be used to describe/mime/how-to-make-money-in-factor-risk-premiathen predict asset returns. Common factors in equity markets are value, momentum, quality, and size. Although these factors have been well-researched and are widely used in stock selection, using them to evaluate bonds is a more recent development.
In fixed income, factors are things like:
Carry: The payoff from holding a bond, etc. with zero change in yield
Value: Identifying bonds that trade cheaply relative to fundamentals.
Momentum — Trying to identify bond price or rate trends.
Quality: Concentrated on bonds of high credit quality.
Bond target: Low vol, which seeks to be less volatile in its price changes.
Opportunities in Factor-Based Fixed Income Investing
1. Enhanced Returns
Factor investing in fixed income has a few compelling appeals – one of which is the return enhancement. Investors seek to add value over traditional factor-agnostic market cap-weighted bond benchmarks by systematically targeting certain factors with their allocations. Academic studies have often shown that some factors—in particular, carry and value — generated systematic positive excess returns in fixed-income markets over time.
2. Improved Diversification
Factor-based strategies can provide a diversifier beyond the traditional bond allocations. This way, investors may combine several pillars to form more durable portfolios that are aligned with different market environments. Such diversification can be especially useful in the current low-yield environment, where traditional fixed-income strategies may find it hard to yield returns that warrant investors´ time and money.
3. Systematic Approach
Factor investing can be a systematic, rule-based tool to help make these bond selection and portfolio construction decisions. It can be useful to remove emotional biases from investment decisions and create a more disciplined process of investments. It is also more transparent and could lead to greater replicability than other discretionary approaches.
4. Cost-Effective Exposure
Factor-based strategies are also known as smart beta and there have been significant strides made in factor investing that have expanded to being offered through exchange-traded funds (ETFs) or other investment vehicles at a low cost. This broadening of factor investing democratizes the strategy, making it accessible to many more investors at a lower cost relative to active management.
Challenges in Implementing Factor Strategies in Fixed Income
1. Data Limitations
Q: What are the most difficult elements to master in factor investing for fixed income? Whereas equity markets are transparent when it comes to pricing and fundamental data, bond markets generally have less available information on prices. Most bonds only trade relatively infrequently, and so good pricing information is often hard to come by. This will make the factor calculations and strategy implementation more convoluted.
2. Market Structure
Factor investing faces constraints particularly when it comes to bond markets. Bonds on the other hand, mostly trade OTC (over-the-counter), unlike centralized exchanges that stocks are traded in. The decentralized nature of the markets can create problems with liquidity and higher transaction costs, especially in those bonds that are not so readily traded as compared to other asset classes. These difficulties may affect factor strategies, particularly those with frequent rebalancing.
3. Complexity of Fixed Income Instruments
Bonds are naturally more complex than stocks with various features like coupon rates, maturities, and embedded options. This complexity makes it harder to have a consistent, comparable measure of the factors across different classes of bonds. For instance, if applying a value factor to corporate bonds we… then need the bond price along with its credit risk and duration etc.
4. Limited Historical Data
Factor investing, like the ones we are looking at here based on momentum and low volatility/minimum variance factors, requires reliance often historical data to ID fickle factor premia. … But, a large proportion of fixed-income markets primarily in emerging economies or in new instruments such as green bonds suffer from poor historical data quality. This paucity of long-term data can make testing and validating factor strategies challenging.
5. Regulatory Environment
Since the global financial crisis in 2008, regulation of fixed-income markets has come a long way. Market liquidity and trading practices have been affected by changes in regulations might change historical factor relationships. Changes Investors Need to Know About and Adverse Impact on Factor Strategies
The Future of Factor Investing in Fixed Income
However, we will likely see further developments in the future of factor investing within fixed income. So, as data accessibility increases and the research in this field continues to progress one would presumably anticipate a higher-level factor strategy with even greater granularity. The biggest areas of growth in things like:
Multi-factor strategies combine different factors into richer, more diversified solutions.
Combining machine learning and artificial intelligence methods to identify new determinants and enhance existing strategies.
Wider evolution of factor investing, especially toward lesser-known corners of the fixed-income market such as emerging market debt and municipal bonds.
Advancement of increasingly specialized factor solutions that provide targeted client outcomes — such as income generation or downside mitigation.
Conclusion
The case for a factor investing approach to fixed income is therefore an area likely of significant interest to investors seeking strong outperformance and diversification within their split focus on yield, perhaps making it the highlighting path forward in 2020. While there are challenges, especially around data and market structure, continued study and technological advances help to solve these problems. Factor-based strategies should emerge as a powerful new lever to help manage fixed-income portfolios well into the future.
While factor investing in fixed income may make sense for some investors, it is unlikely to produce the same type of strong relationships between factors and returns seen in equity markets. Advisers seeking to successfully enter the rapidly growing smart-beta space must be thoughtful about implementing a strategy, diligent in their due diligence on factor definitions and methodologies, and realistic about performance expectations.
And, like any investment strategy a considered and systematic approach underpinned by ongoing due diligence will be needed to ensure factor investing brings new opportunities to the diverse environment of fixed income market.