Fact or fiction? Bond investors can add returns with factor-based investing
In this paper we test whether factor-investing strategies can be implemented in fixed income markets. We are cautiously optimistic about their potential in markets that are liquid enough to support them. For instance, developed sovereign bond markets seem to meet this criterion, but we believe that credit markets currently do not.
There has been an explosion of interest in factor-based investing strategies among equity investors over recent years. Sometimes categorised as smart beta, these strategies seek to add value over traditional market-capitalization indices through the identification of long-run sources of return. They are rules-based, transparent, and generally cheaper than active strategies1.
The success of factor strategies in equities has spawned a growing discussion of whether the concept can also be exploited by fixed income investors. For seasoned investors in fixed income markets, this discussion might seem puzzling – fixed income investors have relied on factor approaches for decades. Factor investing in fixed income, however, takes a different form from factor investing in equities because there are fundamental differences between bonds and bond markets on the one hand, and equities and equity markets on the other.
This note argues that there may be scope for new types of systematically-constructed bond portfolios in some fixed income markets, but that an appreciation of the differences across asset markets is essential to success. In order to highlight these differences, we use the example of corporate credit markets, illustrating the difficulties in applying strategies from equity markets to bond markets. We then consider two approaches in sovereign bond markets: first, a replication of a popular equity strategy (momentum), which struggles to add value; and second, an implementation of commonly-used bond factors, which fares better.
1. We provide an overview of our perspective on factor strategies in ”Primer: the factor drivers of investment returns”, by Ashley Lester, Investment Horizons 6, 2016, Schroders↩