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While factor investing has gained in popularity among equity investors, its range of application is not limited to one asset class. Indeed, BNP Paribas Asset Management has been developing factor-based strategies in fixed income since 2009, initially on government bonds and currencies and more recently on corporate bonds.
This article aims to show that factor investing can not only be applied successfully to fixed-income markets, it is also an approach that is fundamentally different from – and complementary to – what active managers do.
Beyond duration, currency and credit risk: the factors that drive bond markets
The traditional approach to bond investing essentially focuses on actively managing duration, credit risk and/or currency exposure – three parameters that can be characterised as directional risks, i.e. a form of ‘beta’.
Factor investing, on the other hand, aims to delve into all the other sources of risk — and returns — most likely to drive markets. The objective of factor-based strategies is thus to improve risk-adjusted returns by actively targeting these non-directional sources of performance, also called factor premiums (or factor alpha). In practical terms, it means that factor-based strategies are designed to generate performance without taking any active view on the direction of interest rates or credit markets (see Exhibit 1 below).
Exhibit 1: Sources of portfolio risk and returns in equities and bonds
So, what are the factors that drive bond markets? We have found the four following groups of factors (see Exhibit 2 below) to be critical drivers of performance in fixed-income markets:
- The value/carry group: factors that focus on price-related data, mostly with a value for money – or carry for risk – approach
- Fundamental factors: focusing on non-price-related data, such as company-specific data for corporate bonds and country-specific data for government bonds (macroeconomic data, for example)
- Momentum-type factors: based on market dynamics and sentiment, they are a way to capture market moves that may not be fully reflected by fundamentals
- The low-risk factor, which builds on the empirical observation that the bonds with the lowest risk tend to offer higher risk-adjusted returns over the long term. This factor is mostly used in the corporate bond segment.
These diverse factors – somewhat similar in their definition to those used in equity markets – are well-documented in academic research for their capacity to explain long-term returns, and have been the subject of extensive historical testing. They are based on relatively simple concepts, which have been used by active portfolio managers for decades – only in a less formalised and disciplined way.
Exhibit 2: The factors that drive fixed income markets
Practical factor investing considerations: separating factor exposure from market exposure
While the concepts that underpin factors are straightforward and well-recognised, building an efficient factor allocation requires an elaborate investment process.
In particular, one specific area which requires sophistication is the removal of directional biases in a factor.
For instance, let us consider a naïve carry/value factor, which would overweight bonds with high carry and underweight those with low carry. If this factor is not adjusted for beta, it will be biased toward high-beta bonds/countries/sectors, and much of the final performance of the factor will be the result of this beta bias.
Another typical example is when fundamental factors are used to select corporate bonds: if issuers are ranked according to their fundamentals without implementing sector-neutral scorings, some significant sector biases will occur.
A further specific feature of systematic factor-based strategies is that they are risk-budgeted, i.e. that they can allocate a pre-defined budget of risk to factors (either in terms of volatility or tracking error relative to a benchmark). This ensures that the portfolio will maintain a relatively stable risk profile over time.
Hence it is not just the definition of factors (i.e. the choice of indicators), but also the methodology used to build them and to control relative risks that are critical to ensuring a factor-based strategy can generate long-term returns, regardless of the market direction.
From an investor point of view: the benefits of diversification, also in factor investing
As stated previously, one of the main characteristics of factor-based strategies is that they are designed to generate performance without taking any active view on the direction of interest rates or credit markets.
For investors, the implications are twofold. Firstly, in a low-yield/high-valuation environment where directional risks are not particularly well rewarded, these strategies can offer another source of returns rather than just adding more duration, credit or liquidity risk. Secondly, on a broader level, the fundamental differences in the investment approach that is used means that returns from factor-based and traditional strategies will tend to have a low correlation. That means that combining both types of strategies will be beneficial in terms of diversification.
Typically, factor-based strategies can be used as part of investors’ ‘core’ allocation to bring some style diversification relative to other active strategies. Asset allocators can also use factor-based strategies as ‘building blocks’ to implement their top-down views, for example, as an alternative to purely passive indices. Finally, these strategies can generally be implemented in ‘absolute return’ types of products, to be included as part of investors’ diversification bucket.
Furthermore, systematic factor-based strategies have the benefit of being quite simple to customise, either by adapting the list of the factors that are used or by adjusting the risk budget to fit specific investment guidelines.
With the development of factor investing, a new breed of strategies has emerged with the objective of improving risk-adjusted returns by focusing on the underlying drivers of fixed-income markets, such as carry, fundamentals and momentum. By combining these factors efficiently, it is possible to build investment solutions that can be included in any investor’s portfolio and generate diversified returns without adding any significant duration, credit or liquidity risk.Written by Charles Creteil and Olivier Laplenie
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