Systematic bond investing strategies have become increasingly popular among fixed income investors. By adopting quantitative and rules-based approaches, systematic bond strategies aim to consistently identify mispriced bonds to generate alpha. In this article, we will focus on two major systematic factors that have proven effective in bond investing – momentum and value.
The momentum factor exploits the tendency for an asset’s recent relative performance to continue in the near future. The value factor aims to identify cheap bonds that are underpriced relative to their fundamentals. Together, these two factors can help investors systematically spot overvalued and undervalued bonds across various markets and segments.
When constructing a multi-factor bond portfolio, investors typically go long bonds with positive momentum and cheap value while shorting bonds with negative momentum and expensive value. The portfolio is rebalanced periodically based on the latest factor signals. Academic studies have shown that such systematic approaches can consistently generate positive alpha for fixed income investors.
Momentum effect exists in government and corporate bonds
The momentum effect has been shown to produce significant returns in fixed income markets globally. Studies indicate that past medium-term returns of 6 to 12 months contain reliable information for forecasting bond returns for the next month. This momentum effect exists not only in government bonds, but also in corporate bonds.
For example, a research paper by AQR Capital Management examined momentum returns across 13 developed government bond markets between 1985 and 2013. Using past 12-month excess returns to rank bonds, the study showed that a long-short momentum strategy generated significant alpha with low volatility. Importantly, momentum returns have a low correlation with traditional risk factors like duration and credit risk.
Within corporate bonds, multiple studies have also confirmed the power of momentum in predicting future returns. Factors based on past 6-month excess returns of corporate bonds and equities of the issuers are found to be useful for identifying bonds with superior subsequent performance.
Value factor distinguishes cheap vs. expensive bonds
The value factor in fixed income aims to identify bonds that are cheap relative to their fundamentals. Value indicators effectively distinguish expensive bonds with high spreads from cheap bonds with spreads too high vs. default risks.
In government bonds, the value factor ranks bonds based on nominal yields minus matched inflation expectations, exploiting the tendency for real yields to revert to equilibrium. For corporate bonds, quantitative models are constructed to estimate the fair value of credit spreads based on characteristics like duration, rating and volatility.
Empirical research shows that combining value signals from multiple fundamental anchors, such as distance-to-default and credit spread regressions, can produce the most effective composite value factor for credit investing. Just like in equities, cheap value bonds tend to outperform expensive ones as spreads converge towards fundamental values.
Carry and defensive factors improve diversification
In addition to momentum and value, carry and defensive factors are also commonly used in systematic bond strategies. The carry factor simply exploits the tendency for higher-yielding bonds to provide higher returns. The defensive factor focuses on reducing risks by favoring shorter-duration bonds.
Including carry and defensive factors in a multi-factor bond portfolio can further improve diversification. While momentum and value tend to perform well when prices converge towards fundamentals, carry provides positive returns if nothing changes. Defensive provides crisis alpha when flight-to-quality effects dominate markets.
With their low correlation to traditional risk factors like duration and credit spreads, these systematic style factors can act as return enhancers for fixed income investors. They also serve as effective portfolio diversifiers, reducing macroeconomic sensitivities relative to discretionary active bond investing approaches.
In summary, combining momentum and value factors in a systematic bond strategy allows investors to consistently identify and exploit mispricings in fixed income markets. These quantitative factors have proven effective at generating alpha across diverse segments like governments, investment-grade corporates and high yields. Used together with carry and defensive factors, a multi-factor systematic approach can provide high risk-adjusted returns and diversification for bond investors.