Factors have changed the way we invest. But did you know that many of the well-known factors that are found in equities also exist in fixed income? Now, investors are exploring how factors can help build better bond portfolios.

Why invest in fixed income factors?

Fixed income factors are well-documented and researched characteristics that help explain historical and potential drivers of bond returns. Using factor-based insights can help improve portfolios in two key ways:

• Better-informed portfolio construction – Analyzing factor exposures can help identify hidden risks in a bond portfolio, like unintended overweights in interest rate or credit risk. Knowing the true drivers of returns can potentially unlock greater diversification and better overall results.
• Improved investment selection – Understanding factors can help uncover fundamental insights that help improve investment selection within asset classes. For instance, factors can help screen for bonds that have a lower likelihood of default or those that appear underpriced — improving total return potential.

Seeking improved outcomes with fixed income factor ETFs

Factor-based investing can help solve many of the shortcomings in traditional holdings like core bonds, high yield and investment grade corporates.

Diversify Risk in Core Bonds

Most core or intermediate-term bond portfolios are dominated by interest rate risk. For example, the Bloomberg Barclays U.S. Aggregate Bond Index, while made up of over 9,000 bonds from many different sectors, actually derives 80-90% of its risk from interest rates.² As a consequence, your core bond portfolio may benefit from a more diversified approach.

Potential Solution:

Through a factor perspective, it’s possible to rethink core bond portfolio construction using interest rate and credit risk as building blocks. On average, these two risks are negatively correlated, making them key components for diversification.

The iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR) may provide better risk-adjusted returns than typical core bond portfolios by balancing the risk contribution from interest rates and credit spreads. Compare a hypothetical $10,000 investment in FIBR versus the average bond mutual fund to see the results.

FIBR has delivered better returns vs. other bond funds

Source: Morningstar, since FIBR inception from 2/24/15 to 9/30/18.
The chart reflects a hypothetical $10,000 investment and assumes reinvestment of dividends and capital gains. Fund expenses, including management fees and other expenses were deducted. Intermediate-Term Bond Category returns represented by the average NAV returns of the Morningstar U.S. Intermediate-Term Bond Fund Category which included a total of 867 ETFs and mutual funds. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance, see www.iShares.com. For standardized performance, please click on the fund name above.

Seek High Yield with Less Risk

High yield bonds are essential to generating above average yields. However, one drawback to investing in high yield bonds is the increased probability of defaults and the accompanying volatility the asset class introduces to a bond portfolio.

Potential Solution:

Using a factor approach, it is possible to invest in high yield with potentially less risk, while still pursuing a similar level of yield and returns. The iShares Edge High Yield Defensive Bond ETF (HYDB) seeks to track an index that combines quality and value factors to invest in high yield bonds with a more defensive tilt.

The index of HYDB aims to screen out bonds that appear to be lower quality based on well-researched credit metrics and then overweighs the remaining bonds that appear undervalued. The targeted result is a portfolio with similar income and return potential but with potentially less risk than a market-cap weighted allocation.

Similar levels of yield with potentially less risk

Source: BlackRock, Bloomberg Barclays Indices, from 5/31/17 to 9/30/18.
Defensive High Yield Bonds represented by the BlackRock High Yield Defensive Bond Index. High Yield Bonds represented by the Bloomberg Barclays U.S. Corporate High Yield Index. Yields are measured as weighted average yield to maturity. Upside and Downside Capture Ratio measures if a given strategy has outperformed--gained more or lost less than--a market benchmark during periods of market strength and weakness, and if so, by how much. 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. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com

Seek Enhanced Returns in Corporates

Years of low interest rates have kept investment grade bond yields well below historical levels. Now, many bond investors have been forced into a difficult decision – sacrifice yield for the perceived stability of investment grade bonds or reach into historically more risky asset classes.

Potential Solution:

Using fixed income factors, there may be a way to get more from your investment grade bond allocation. Investors seeking income while potentially enhancing returns can consider iShares Edge Investment-Grade Enhanced Bond ETF (IGEB). The index of IGEB aims to deliver better risk-adjusted returns relative to the broader investment grade corporate bond market by using proprietary credit analytics that target high quality and undervalued bonds.

Corporate bonds with historically improved risk and return trade-off

Source: BlackRock, Markit, from 5/31/17 to 9/30/18.
Enhanced Corporate Bonds represented by the BlackRock Investment Grade Enhanced Bond Index. Corporate Bonds represented by the Markit iBoxx USD Liquid Investment Grade Index. Annualized Risk based on standard deviation. 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. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.