Fixed income factor investing has become increasingly popular over the recent years. By tilting the portfolio towards certain factor exposures, investors aim to enhance returns and diversify risks. This article provides an in-depth analysis on major fixed income style factors and how to construct effective factor-based strategies.
Four major style factors: Value, Momentum, Carry and Defensive
There are four major fixed income style factors that have shown robust historical returns: Value aims to identify cheap vs expensive bonds; Momentum intends to profit from trends; Carry focuses on earning carry; Defensive emphasizes stability. These factors have low correlation with traditional risk factors like term premium. A diversified multi-factor portfolio could significantly improve risk-adjusted returns.
Strategic style diversification across countries and maturities
The factor portfolio invests across various markets for government bonds and credit ratings/durations for corporate bonds based on factor rankings. This strategic diversification method provides exposure to different risk-return characteristics and enhances portfolio efficiency. Value and Momentum are applied cross-country, Carry within country and Defensive across maturities.
Challenges of traditional active management
Although active fixed income managers have delivered excess returns, much of the outperformance can be attributed to passive exposures rather than alpha. Overweights in credit risk change the correlation between fixed income and equities from negative to positive, reducing the diversification benefit.
Benefits of factor investing strategies
A style-oriented fixed income strategy serves as an attractive return-enhancer in a low-yield climate, and also a portfolio diversifier due to low correlation with market risk factors. By focusing on historically rewarded factor premiums, investors can enhance risk-adjusted performance.
In summary, fixed income factor-based strategies provide exposures to diverse return drivers uncorrelated to market risks, allowing investors to improve portfolio efficiency. When integrated appropriately, factor investing presents an effective approach to fixed income portfolio construction.