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.
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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.
What you need to know about fixed income factors
Get the answers to common questions about fixed income factor investing.
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What are fixed income factors?
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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What are the different types of fixed income factors?
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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What are macro factors in fixed income?
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. -
What are style factors in fixed income?
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.Carry
What?
Higher yielding bonds relative to other similar bonds.Why?
All else equal, higher-yielding assets tend to outperform lower-yielding assets.Low Volatility
What?
Stable, less volatile bonds compared to other similar bonds.Why?
Low volatility can lead to improved returns over the long-term. -
Opportunities and challenges of factor investing
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.
* Net expense ratios shown for FIBR and BYLD reflect contractual fee waivers in place until 2/29/24 and 2/28/21, respectively. Gross expense ratios are 0.26% and 0.53%, respectively.
† Source: Morningstar, as of 9/30/18. Represents the average prospectus net expense ratio of open-end funds in Morningstar U.S. Intermediate-Term Bond Category based on the I-share or least expensive share class.
1 Source: Morningstar, as of 9/30/18. Comparison is between the average Prospectus Net Expense Ratio for the iShares fixed income factor ETFs (0.26%) which includes FIBR, HYDB, IGEB, BYLD, FALN, and the fixed income active open-end mutual funds (0.92%) available in the U.S. (excluding money market funds).
2 Source: BlackRock Solutions. Using monthly Bloomberg Barclays Index data between January 1989 and December 2014, interest rate risk was ~90% of the Bloomberg Barclays US Aggregate Bond Index's total risk.
Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.
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Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Brokerage commissions will reduce returns. Market returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. eastern time (when NAV is normally determined for most ETFs), and do not represent the returns you would receive if you traded shares at other times.
Certain sectors and markets perform exceptionally well based on current market conditions and iShares Funds can benefit from that performance. Achieving such exceptional returns involves the risk of volatility and investors should not expect that such results will be repeated.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
A fund's use of derivatives may reduce a fund's returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that any fund's hedging transactions will be effective.
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There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.
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