In contrast with traditional bond investing, which often focuses on actively managing a portfolio’s sensitivity to changes in interest rates (duration), credit risk and currency exposure, factor investing involves picking securities based strictly on specific characteristics. These ‘factors’ have been shown to explain investment performance over time.
In other words, instead of taking positions around the expected course of markets, factor-based strategies are designed to generate performance irrespective of the direction of interest rates or corporate bond markets.
The aim is to pick bonds that will outperform similar securities. We believe this non-directional slant is an asset in today’s volatile markets. It can help limit drawdowns during steep market falls, as was the case around this time in 2020.
A different look at factors in corporate bond investing
Factor-based investing in corporate bonds is not as straightforward as in equities, where it has been used for more than a decade. The factors have the same names – value, momentum, low risk and quality – but investors should take these differences between bond and equity investing into account:
- What matters to an equity investor may not matter to bond investors. For instance, in the case of a leveraged buy-out, shares in the company may rise after the announcement, while the increased debt load may hurt its bonds.
- Bond investors are concerned by the ability of
issuers to repay their debt, while equity investors look for companies which
can grow their businesses.
- An illustration: in equity investing, a typical value factor is the price-to-book ratio. This aims to identify undervalued stocks by comparing the stock price to the book value of the company. The factor would buy stocks with low price-to-book ratios, seeking to benefit from the rebound of undervalued stocks.
- In corporate bond investing, the factor works the other way around: it is used to avoid value traps - undervalued companies that may not recover.
- There are different aspects to bond investing. For each company, there may be many bonds with different maturities and specifications, and hence different risks. The risk of a bond changes as time passes because the time-to-maturity decreases. So, portfolio construction needs to take into account several risk dimensions: credit risk, interest rate risk and time. Instead of scoring bonds globally, you need to score bond locally, by comparing them to issues with similar risk premiums and maturities.
- Bonds do not offer investors the same upside potential as equities: when you invest in a bond, you will earn its yield (= coupon + change in bond price). Accordingly, for bond investors, capital preservation matters: the focus is on avoiding companies that may default or be downgraded and drop out of the main bond benchmarks.
Using factors, we seek to tilt corporate bond investments towards the cheapest, most profitable and well-managed companies with the lowest risk and strongest momentum. This makes intuitive sense and is a proven way of targeting higher risk-adjusted returns over the long term.
How do investors benefit?
Factor-based investing in corporate bonds adds diversification to portfolios.
Given that a multi-factor portfolio is built to maintain the same risk as that of the benchmark, it tends to have a different – non-directional – risk profile. Unlike more traditional strategies, it is not focused on implementing active views in terms of duration, yield curve positioning or sector allocation.
This helps to make such a portfolio more resilient in periods when market volatility increases suddenly, like what we observed in 2020. We believe this underscores our view that multi-factor investments should typically be used as strategic core investments.
How much should an investor allocate to such a portfolio? In other words, do the excess returns of multi-factor strategies efficiently complement other excess returns? Since there is no strong structural correlation between multi-factor excess returns and the excess returns from traditional strategies, we believe multi-factor investments are indeed a good addition, acting as a robust diversifier and improving the risk/return profile versus the benchmark.
We believe the optimal allocation to multi-factor strategies is between 30% to 50%, in order to efficiently reap the diversification benefits. Obviously, this may differ across investors, depending on the existing investments they have in their portfolios.
What about taking extra-financial criteria into account?
Sustainability considerations are at the core of our approach. In practice, we exclude the worst issuers in terms of environmental, social and governance (ESG) ratings because we believe these companies bear a higher long-term risk, both in terms of financial performance and reputation.
Beyond simple exclusions, we work with non-financial criteria to select bonds and build a portfolio that has a materially better overall ESG score than the benchmark and whose carbon footprint is 50% lower. Our assessment includes direct CO2 emissions from owned or controlled sources and indirect emissions from the generation of purchased electricity, steam, heating and cooling. We want to have a measurable impact on sustainability.
We believe these green credentials add to the attractiveness of multi-factor corporate bond strategies as a complement to more traditional strategies, as a core strategic allocation, and as a diversifier that can help improve overall performance.
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. This document does not constitute investment advice.
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. Past performance is no guarantee for future returns.
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.