The majority of fixed-income managers’ excess returns come down to just two things: a bond’s life, or duration, and the quality of the company that has issued it.
With that in mind, Northern Trust Asset Management set out to research how low-cost systematic approaches can improve potential outcomes for fixed-income investors. The research shows that using a factor-based or systematic approach can help expand the sources of return for investors, particularly as they struggle with low yields and the possibility of future inflation.
Factors are sources of return beyond what the market overall can deliver and can be increasingly accessed using low-cost funds. Factors are more widely accepted and used in equities — think of the value or growth premium. But better data, bond prices, and trading efficiency in corporate bonds has fueled a growing body of academic research on fixed income factors.
NTAM researchers found that 70 percent of excess returns of actively managed fixed income funds can be traced to simple exposures to factors such as duration and credit. They also determined that systematic factors may offer more opportunities to earn income without taking too much credit risk or tying up money in illiquid investments.
“This suggests that managers may outperform in the long run simply because of static beta exposures to these systematic factors vis-à-vis longer duration biases or an overweight to specific credit sectors,” according to the paper’s primary authors Manan Mehta, NTAM’s head of quantitative fixed income research, and Mike Hunstad, head of quantitative strategies.
That’s not necessarily a problem, they argue.
But, according to the study, investors need to be aware that these market-like exposures can be accessed through cheap exchange-traded or traditional mutual funds.
Factors in the fixed income world have become increasingly popular over the last few years. In part, that’s because investors can more easily implement these types of portfolios and there’s far more data on everything related to a bond, giving investors a better picture of the markets. Although it’s still more expensive to buy and sell fixed-income securities than stocks, the cost has fallen as more electronic platforms to trade corporate bonds have emerged.
NTAM has identified multiple factors — including value, momentum, and low volatility — in fixed income, many of which mirror those in stocks. By using these factors, the authors said, investors can more efficiently make a credit bet or get more yield without taking on more risk that an issuer will default.
“Factors provide the ability to move beyond term and credit positioning and create additional portfolio levers. They are an attempt to explain and achieve improved returns by exposing portfolios to compensated drivers of returns,” wrote the researchers.
According to the paper, a global investment-grade strategy that uses quality and value factors generates more yield (1.55 percent) relative to the benchmark (1.33 percent). At the same time, it has a similar level of credit risk as the benchmark.
NTAM’s research also covered potential factors based on environmental, social, and governance goals. Analyzing data going back to 2008, they found that “bonds with higher ESG ratings offered downside mitigation during periods of market turbulence despite their low correlation to traditional credit ratings.”
