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How factor investing can offer greater clarity on bonds

The bond market is a complex and diverse area to invest in. It is a real challenge to navigate due to the different types of risks and returns that exist. Factor investing can help provide greater clarity for investors looking at fixed income and could allow them to make better and more informed investment decisions.

October 13, 2021

An innovative investment strategy for fixed income

Factor investing allows investors to get a good view of the different performance drivers in fixed income. It offers a framework to help manage exposure to each risk factor. It can also be used to help open up and illuminate new dimensions of risk that traditional fixed-income portfolio managers might not have focused on in the past.

The fixed-income risk landscape has changed

The investment environment has changed significantly for fixed income over the last few years – a fact that could make factor investing extremely valuable. Sovereign and corporate borrowers have taken advantage of current ultra-low interest rates and have been issuing more bonds and bonds with a longer maturity to lock in cheaper financing. Consequently, this has had a meaningful impact on the risk landscape that fixed-income investors face.

For instance, duration (interest-rate risk) has gradually risen. Meanwhile, the share of BBB securities has also increased significantly – in some cases even doubled – across most broad-based investment-grade bond indices since the start of the millennium. This means that if you invest in a market index, the level of interest-rate and credit risk that you are exposed to will have risen, potentially without you realizing it. Therefore, understanding portfolio risk has become more important than ever, which is why factor investing is so valuable.

Factor investing

 

The bigger picture

The most important attributes of successful investors include the ability to capture the determinants as a whole and link them together. This produces the big picture. It shows the entire investment spectrum and creates transparency to make investment decisions easier.

We need to understand what fixed-income factors exist

Mapping out the risk factors that exist in fixed income is extremely important. Factor investing is all about understanding individual sources of return and applying that knowledge to improve a portfolio’s risk/ return characteristics to generate alpha – a portfolio’s outperformance compared to a benchmark.

Although factor investing is already widely accepted by equity investors, it is now gaining traction with fixed-income investors. In the current low yield environment, many fixed-income investors are keen to boost their returns while keeping their risk balanced. Additionally, they might be able to achieve this by carefully managing the different risk factors that they are exposed to.

Why risk-factor investing in fixed income is complex

Although factor investing has been applied to a wide array of asset classes, its footprint in the fixed-income sector remains small. This is due to the challenges that are specific to bond markets, such as the vastness and complexity of the bond universe itself.

Equities are standardized, interchangeable instruments that are transparently traded on an exchange. By contrast, bonds are not standardized at all. There are many different types of issuers, including corporations, governments, and supranational organizations. And each issuer can issue bonds with different maturities, optionality, seniority, and currency.

There are other factors to contend with as well. While numerous new bonds are issued every day, existing bonds can also be called and repaid. To make matters worse, third-party data, such as credit ratings, plays a crucial role in how bonds are priced, but this data is updated only periodically and lacks sufficient granularity.

This complexity makes quantitative comparisons between bonds extremely difficult, which in turn makes factor modeling for fixed income a very challenging exercise.

Source: Invesco Global Factor Investing Study 2020

Technology is crucial for making fixed-income factor investing work

The characteristics of the fixed-income universe underscore the importance of using technology to develop, deploy, and manage quantitative strategies. Technological innovation in the form of efficient data management systems that allow for daily updates is essential. Furthermore, these databases need to support quantitative modeling to overcome the shortcomings of lagging third-party data by running statistical models on millions of data points. Finally, customizable optimization software is needed to incorporate specific client demands and to avoid one-sided portfolio positioning and concentrated risks when calculating the optimal security selection.

Since factor investing is a quantitative approach to portfolio management, it naturally follows that risk management and monitoring processes should be quantitatively driven as well. That is why the ideal factor-investing engine can generate optimal security selections subject to a variety of constraints like portfolio duration, ESG criteria, or sector exposure. It also monitors the actually implemented portfolio for changes in factor loadings. For example, this could be due to deteriorating credit quality or reduced relative value. This approach can create rebalancing suggestions over time.

However, like any investment approach, quantitative models also have their limitations. To mitigate the pitfalls of factor models and quantitative investing in general, human oversight is needed to review and challenge the model’s output. This includes scrutinizing portfolio candidates for risks that are not covered by the model, such as poor corporate governance. It also includes reviewing rebalancing suggestions based on available market liquidity and gathering general market intelligence to keep track of corporate actions, new issues, and price-relevant information on specific issuers.

Benefits for investors

Factor investing presents a promising supplementary investment opportunity for fixed-income investors. Factor-driven portfolios empirically deliver enhanced risk-adjusted returns compared to the benchmark.1 This relative outperformance stems from the systematic selection of securities, which helps harvest premiums for each of the factors considered, be it for quality, value, or liquidity. In addition, factor-based strategies provide effective diversification compared to more traditionally managed bond portfolios because factors typically exhibit low or negative correlations to common market risks.2

Employing a “quantamental” investment process is important. This requires combining pure quantitative analysis with fundamental insights. Consequently, investors benefit from an automated investment approach that applies factor-investing principles to fixed income, while also actively managing the complexities of the fixed-income universe.

Overall, factor investing helps investors manage their bond portfolios toward a set of individual risk drivers. This could potentially help them achieve better risk-adjusted returns over the long run, compared to the usual debt-weighted approaches.

 

Factors targeted in fixed income

(% citations, fixed income factor investors)

Sample size: 86, Source: Invesco Global Factor Investing Study 2020

Risk warning

1 Paarmann, T. (April 8, 2021). Introduction to Factor Investing. Invesco. https://www.invesco.ch/en-ch/insights/introduction-to-factor-investing.
PIMCO. (June 21, 2021). Risk Factor Diversification. Pacific Investment Management Company LLC. https://www.pimco.ch/en-ch/resources/education/understanding-risk-factor-diversification.