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Factor investing in corporate bonds – The new kid on the block

Using factors when investing in corporate bonds is still in its infancy. However, interest among investors has been growing quickly. Here we summarise our most recent paper on this topic. After discussing why it has taken so long for factor research to be applied to corporate bonds, we explain why we believe this type of investment management is now set to take off.

  • There are various reasons for past reticence on using factors for corporate bond investment strategies
  • Our research shows that factor-based corporate bond selection can result in risk-adjusted outperformance of market cap-weighted indices over time [1][2]

Equity managers have relied on factors for decades

Factors are characteristics that play a role in explaining the returns and risk of a group of securities.

A factor research-based approach has been successful when applied to investing in equity markets. Both academics and practitioners have published a vast number of papers on the topic.

Factors can be used to forecast both risk and returns of stocks and portfolios of stocks.

Of particular interest have been those factors assessing how cheap, profitable, risky or trending investing in a company is. This is because these are the factors that have been found to determine whether any given stock is likely to outperform its peers in the future.

It is for this reason that these four factors have been the bread and butter of managers of active equity strategies using quantitative stock selection techniques for decades. They have used the factors to construct portfolios invested in the stocks of the cheapest, most profitable, less risky companies with the strongest price trends.

And, despite the occasional bad year, such quant equity active managers have had successful track records of outperformance based on such models for decades.

Why have active managers of corporate bonds not also used factors?

Perhaps surprisingly, corporate bonds have not been looked at from a comparable angle. At least, not until recently.

Our paper ”Factor Investing in Corporate Bond Markets: Enhancing Efficacy Through Diversification and Purification!” published in December 2019 in The Journal of Fixed Income, discussed the topic at length. It demonstrated that factors can be applied equally to corporate bonds. Our paper joins a short list of work on this topic. So far, other papers have been written mainly by practitioners.

As we explained in our paper, there are a few likely reasons why corporate bond fund managers and academics have so far been shy about using factors. Their reticence is probably related to these differences between corporate bond markets and equity markets:

  1. At any point in time and for each company, there may be many bond issues of different maturities and with different specifications, hence many different risk profiles.
  2. The risk of each bond changes as time passes because the time-to-maturity decreases.
  3. Unlike most equities, corporate bonds trade in often fragmented and opaque over-the-counter (OTC) markets.
  4. Corporate bonds have relatively poor market liquidity: many are of them not easy to trade. This is because a significant number of investors buy and then hold them until maturity.
  5. The intrinsic nature of debt: unlike stocks, where investors may expect to earn outsized returns from companies that see their market capitalisation growing significantly over time, the returns earned by bond investors lending to those same companies is not as significantly impacted by the rising equity capitalisation. A company with a growing market capitalisation may simply take advantage of this to increase its debt by issuing more bonds without any visible impact on the returns earned by existing bondholders.
  6. Exploring factors based on fundamental data is more difficult for corporate bonds because it requires linking the pricing data of the individual bonds of a given issuing company to the fundamental characteristics of the company in a robust manner.

Factor investing applied to corporate bonds is here to stay

Nevertheless, once all these obstacles are dealt with, it is apparent to us that corporate bonds with stronger market momentum and from cheaper, more profitable and less risky issuers can generate higher risk-adjusted returns than corporate bonds with weaker momentum from more expensive, less profitable and riskier issuers.

Tilting portfolios in favour of such outperforming bonds while controlling for risk and portfolio turnover results in systematic investment strategies likely to outperform market capitalisation-weighted benchmark indices over time. 

Our paper includes positive results for US investment-grade, euro investment-grade and US high-yield market segments.

Expect significant growth in factor investing in corporate bonds

We believe that factor investing in corporate bonds is just starting. Investors expect more rigour from asset managers and the development of quantitative approaches.

That is why in coming years we expect a growing interest in this style of investing. In our view, this should lead to significant growth of the assets under management in these strategies.

[1] Please note that this document may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

[2] Most bond indices are weighted by market capitalisation. A problem occurs when less creditworthy issuers with a lot of outstanding debt constitute a larger part of the index than more creditworthy ones.[1]


Also read Factor investing in equities and corporate bonds – a toolkit

More articles by Raul Leote de Carvalho

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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