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Key takeaways

  • A “reach-for-yield” mindset in a low-rate environment can lead investors to inadvertently take on more credit risk than they may want.
  • Index-tracking funds that emphasize value and quality factors can help target overlooked, less expensive corporate bonds.
  • iShares ETFs offer efficient solutions to help navigate challenges in fixed income investing.

A conundrum of the persistently low-interest rate environment: Seeking the highest-yielding bonds often means taking on more default risk, or loading up on popular (and richly priced) bonds.

It’s no surprise that many bond investors have gravitated toward riskier, higher-income-paying bonds to hit income-generation targets in recent years. Yet while such “reach for yield” behavior can pay off during prolonged rising markets, it can be potentially detrimental in downturns.

One approach for striking a balance is to consider “factor”-based strategies that screen the universe of bond holdings with the aim of excluding those that are riskiest. Factors have been widely adopted by stock investors, and we think that the current low-interest-rate market environment makes such strategies increasingly relevant to bond investors.1 In particular, “quality” and “value” factors can provide compelling solutions in a yield-starved fixed income world.

Pardon my (over)reach

When many investors overreach for yield simultaneously, their one-sided investment behavior can create opportunities elsewhere in the market. In particular, the focus on yield can leave riskier bonds overpriced relative to their expected return per unit of risk. The flip side is that less risky bonds, which have been overlooked by those chasing yield, can offer potential for higher risk-adjusted returns, or more expected return per unit of risk.2 I hear often in conversations with investors about a need for strategies focused on “reaching for quality” within the corporate bond market, in other words strategies that help people stay invested without giving up the opportunity for strong performance.

A one-two factor punch: quality and value

One way factors can potentially be useful in this environment is to help screen out debt issued by companies most likely to default. For example, certain iShares exchange traded funds (ETFs) seek to track factor bond indexes that screen for quality by using stock and bond price data, corporate accounting data, credit rating histories, and other economic variables to estimate probability of default over the next 12 months.

An important next step, after screening out the least-healthy bonds, is finding the cheapest bonds among the high-quality bonds that remain in the investable universe. Put another way, if you only screened for quality, your portfolio may just be made up of expensive bonds. A screen that helps to “tilt” toward value helps emphasize bonds that are cheap relative to their peers and based on their fundamentals, after accounting the probability of default.

Applying factor rules to iShares bond ETFs

Screens for quality and value can be applied by investors who want access to corporate bonds — but with less expected risk and return potential that may exceed the market. The availability of rules-based index ETFs that build in the screening process now makes it possible for investors to access these solutions at a low cost.

The iShares Investment Grade Bond Factor ETF (IGEB) and the iShares High Yield Bond Factor ETF (HYDB) are low-cost3 ETFs that seek to track fixed income factor indexes.4 They have delivered strong performance compared to traditional market capitalization weighted benchmarks and peers in recent years. Notably, their performance puts them in the top decile of their respective Morningstar Corporate Bond and High Yield bond categories over three years.5

Figure 1: Performance compared to market capitalization weighted benchmarks and Morningstar peer universes

Chart: Performance compared to market capitalization weighted benchmarks and Morningstar peer universes: Investment Grade

 


Chart: Performance compared to market capitalization weighted benchmarks and Morningstar peer universes: High Yield

Source: Morningstar, Bloomberg, BlackRock, as of 12/31/2020. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end and Market Price returns may be obtained for IGEB and HYDB by clicking on the ticker. IGEB and HYDB incepted on Jul 11, 2017. Other time periods may have different results. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Summing it up

The low-yield environment is likely to persist for the next few years. In such conditions, it’s tempting for investors to continue reaching further for yield. One alternative is index-tracking factor ETFs that can help deliver better risk-adjusted returns relative to the broader investment grade and high yield corporate bond markets by using credit analytics that target high quality and undervalued bonds.

Karen Schenone, CFA
Head of U.S. iShares Fixed Income Strategy
Contributing authors: Dhruv Nagrath, Chris Zaiko
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