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.
Target 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.
Seek outperformance at a low cost
Most core or intermediate-term bond portfolios are dominated by interest rate risk. For example, the Bloomberg 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 to generate returns.
Putting factors to work
Through a factor perspective, it’s possible to go beyond market cap-weighted portfolio construction in an effort to overcome some of the shortcomings of broad bond market indices.
The iShares U.S. Fixed Income Balanced Risk Factor ETF (FIBR) may provide better income potential with lower duration than a typical broad bond portfolio by seeking a better balance between interest rate risk and credit risk.
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.
Putting factors to work
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 High Yield Bond Factor 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.
How the index is built
For illustrative purposes only.
Based on the methodology of the BlackRock High Yield Defensive Bond Index.
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.
Putting factors to work
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 Investment Grade Bond Factor 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.
How the index is built
For illustrative purposes only.
Based on the methodology of the BlackRock Investment Grade Enhanced Bond Index.
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What you need to know about fixed income factors
Get the answers to common questions about fixed income factor investing.
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Like equity factors, fixed income factors are well-researched and economically intuitive drivers of returns. They have delivered a premium to investors over long-time horizons because of one or more of the following reasons:
- Rewarded risk – Historically you can earn additional returns for taking on higher risk.
- Structural impediment – Market rules or restrictions make some investments off-limits to certain investors which may result in assets being mispriced.
- Behavioral bias – Not all investors behave rationally all of the time, creating contrarian opportunities.
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Fixed income factors can be divided into two general categories that offer investment opportunities - macro factors and style factors.
- Macro factors capture broad risks that explain returns across asset classes. These are economy-wide sources of risk such as interest rates, inflation and credit risk.
- Style factors explain risks and returns within asset classes. They are characteristics, such as quality and value, which explain the outperformance of certain bonds relative to other bonds in the same sector or asset class.
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Within fixed income, there are five rewarded macro factors that drive returns.
Factor Explanation Real Rates
What?
The potential reward for taking on the risk of interest rate movements.Why?
Rising real interest rates decrease the market value of nominal bonds. Real rate sensitive assets have tended to perform well in declining rate environments and underperform in rising rate environments.Inflation
What?
The potential reward for taking on the risk that the purchasing power of money may change.Why?
If an investor purchases a government bond that matures at a par value of $1,000 in 10 years, the investor will be worse off if the purchasing power of the currency weakens because the $1,000 maturity value will have eroded.Credit
What?
The potential reward for taking on default risk.Why?
Bonds are effectively loans that investors make to the bond issuer. Investors can earn a premium by lending money to corporations because there is some risk that the issuer may default.Liquidity
What?
The potential reward linked to how hard it is to buy or sell an asset.Why?
Investors holding less liquid assets accept the risk that they may not be able to immediately sell their investment in certain environments. By foregoing immediate access to capital, investors may be paid an “illiquidity” premium.Sovereign
What?
The potential reward for taking on the political and fiscal risks associated with foreign countries.Why?
Investors can earn a premium by bearing the additional risk associated with lending in less developed and less stable markets, including the risk of political turmoil, currency devaluations, and seizure of foreign assets. -
Our approach to style factors focuses on factors that demonstrate the ability to create value for investors, provide a potential source of diversification, make intuitive economic sense and that can be implemented efficiently.
Factor Explanation Value
What?
Bonds that are inexpensive relative to other similar bonds.Why?
Bonds that are undervalued may have a tendency to have upside appreciation potential, which can lead to higher returns over time.Quality
What?
Bonds issued by companies with healthy balance sheets and sound fundamentals.Why?
Bonds who have issuers with strong fundamentals may have a lower probability of default over bonds with weaker fundamentals.Momentum
What?
Bonds with recently improved credit ratings or market sentiment.Why?
Bonds that have currently appreciated may be likely to continue to benefit following changes in sentiment or price changes.Low Volatility
What?
Stable, less volatile bonds compared to other similar bonds.Why?
Low volatility can lead to improved returns over the long-term. -
By evaluating all asset classes through a factor lens, investors can develop a better understanding of portfolio risk and return, and construct more robust portfolios better tailored to meet desired investment outcomes. Fixed income is no exception and a number of strategies — be it mitigating interest rate risk or capturing credit risk premia — already exist and have demonstrated successful outcomes.
However, given the challenges of targeting factors within fixed income and the relative infancy of the fixed income smart beta landscape, we believe it’s best to consult with an experienced smart beta investment provider in order to better understand and benefit from fixed income smart beta strategies.