The Fixed Income Side of Factor Investing: What Investors Need to Know
Factor investing is a popular strategy for equity investors, but in fixed income markets, it has only come into the fore more recently. That said, a key advantage for fixed income investors is that some of the same factors that have been implemented by equity investors can also be used to generate alpha in the bond market. In this piece, we focus on the Value and Momentum style factors.
Importantly, some of the traditional factors in stock markets (like Value and Momentum) have already been widely adopted, and they are becoming more and more commoditized in the equity trading space. Fixed income investors have the opportunity to take advantage of risk-adjusted return benefits from being early movers in fixed income factor investing.
Learning from Patterns
Historical data shows that certain market trends and inefficiencies have existed since the inception of equity trading. Alpha generation has since been borne out in trading strategies that take advantage of these anomalies. In particular, factor investing exposes portfolios of securities to common sources of systematic risk (such as styles, sectors, and regions) in order to put these anomalies to work and improve risk-adjusted returns. As mentioned, many of the popular factor trading techniques on the equity side are already in heavy use by equity traders, causing a reduction in the factor premium.1
Fixed income markets have more recently entered the factor investing area, as data shows that many of the same patterns that have repeatedly been revealed in equity markets can also apply to fixed income securities. As a result, fixed income investors can now use factors that expose them to bonds that may have higher returns in the future if historical trends pan out.
There are two types of factors: “risk” factors and “style” factors. In this piece, we focus on the Value and Momentum style factors, which are applicable to both equity and fixed income markets.
Combining Diversified Factors
When implementing factor investing strategies, an important goal for investors is to find multiple factors that are diversifying relative to each other, but provide greater excess return when combined. The idea is to find outperformance, but in different ways. Importantly, by effectively combining signals, fixed income investors can gain diversification benefits and potentially improve portfolio returns.
Indeed, Polbennikov, Desclée, and Dubois2 illustrate this result with an example based on a combination of Value and Momentum factor strategies. They found that a portfolio constructed to optimize a 50/50 blend of Value and Momentum signals achieved significantly better performance — in terms of average outperformance and information ratio — than a 50/50 blend of two portfolios that independently optimized each signal on its own.3 As a result, Value and Momentum are two factors frequently combined to both diversify each other and boost returns.
A broader analysis across asset classes shows that the negative relationship between Value and Momentum factors is consistent regardless of whether equity or fixed income strategies are in place (Figures 1 and 2). Furthermore, when looking at each factor in isolation, equity Value is positively correlated to fixed income Value, and the same holds true for Momentum. Many alpha strategies are looking to take advantage of the Value factor, but by complementing Value with Momentum, we seek to prevent an overabundance of the general pro-cyclicality of Value. This can lead to a competitive and differentiated outcome relative to fundamental managers.
Fixed Income Investors Can Obtain Important Benefits from Factor Investing
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Systematic active fixed income investing allows investors to take advantage of the performance benefits of making positive tilts towards certain alpha factors, including Value and Momentum.