Fixed income factor investing has become increasingly popular in recent years as a way to enhance returns and diversify portfolios. By tilting portfolios towards certain factors like value, momentum, carry and defensive, investors can tap into systematic return premiums. Recent research has shown that factors not only exist in equities but also in fixed income markets. Factors can be applied across countries to government bonds and across companies and industries for corporate bonds. A multi-factor bond portfolio has low correlation to traditional market risks like duration and credit spreads. It provides attractive risk-adjusted returns that persist across different time periods and market environments.
Factors provide systematic return premiums in fixed income
The key factors that have been shown to earn premiums in fixed income markets include value, momentum, carry and defensive. Value aims to identify cheap bonds relative to a fundamental anchor. For governments, this anchor is typically the yield spread over inflation expectations. For corporates, it is the credit spread over default expectations. Momentum simply looks at past excess returns over Treasuries to predict future returns. Carry earns an excess yield by holding higher yielding bonds. Lastly, defensive investing focuses on lower risk bonds such as short duration governments.
Multi-factor approaches enhance portfolio diversification
While single factors all provide positive premiums historically, combining multiple factors into one portfolio significantly enhances returns and diversification. The returns from different factors have low and sometimes negative correlations. This means they provide unique sources of systematic returns that respond differently across varying economic regimes and market cycles.
Factors complement traditional active fixed income strategies
Most active fixed income strategies earn returns by overweighting credit risk relative to benchmarks. However, research has shown that this credit risk tends to dominate returns, meaning there is little true alpha. Adding factors tilts portfolios away from credit into systematic exposures that are largely unrelated to credit markets. This makes them complementary to traditional active approaches and improves overall portfolio diversification.
Factors can be implemented across public and private markets
Fixed income factors have historically been studied in public bond markets but are also relevant for private credit. For example, factors could be measured using discounted cash flow models on leveraged loans. Given their illiquidity and complexity, factors may be even more likely to persist and provide returns in private markets.
In summary, fixed income factor investing provides an additional toolset for portfolio managers to improve diversification and enhance risk-adjusted returns. As this area continues evolving, investors should expect an expanded set of fixed income solutions tapping into different factor premiums across various market segments.