At Morningstar: Using Factors in Fixed Income Investing Remains Difficult

Equity strategies may not stand up to the complexity of the fixed income markets.

Factor are well-known in the equities market and certain strategies like value and quality have academic rigor to back up their outperformance over benchmarks.

Now these strategies are making their way into the fixed income market, but two market experts caution there’s a lot more complexity to debt markets than equities when it comes to using these tools to gain outperformance.

Unlike in equities, where there are decades of academic research to prove how the classic factor attributes work, fixed income factor research is shallow. Speaking Friday at the Morningstar Investment Conference in Chicago, Jordan Brooks, principal at AQR Capital Management, said a dearth of data has prevented much research into how factors work in fixed income since most debt markets aren’t traded on exchanges. That started to change in 2002, when high-quality transaction-level corporate bond data started to become available, he added.

With academic research still relatively recent, there’s little consensus that equity factors can be easily applied to the fixed income markets.

It is possible to use factors in fixed income, but Matt Tucker, managing director for BlackRock/iShares, said there are a host of considerations. “The equity factor approach is not directly, easily transferred to fixed income,” Tucker told the Morningstar audience.

The reason factors aren’t easily transferable in part is because in the equity market, idiosyncratic risk drives the return, Tucker said. In the fixed income market, depending on the time period, 79% of the return is driven by rates and credit. But other elements like liquidity and sovereign risk also play a role, he adds.

Style factors drive the return in an equity market, Tucker said. These style factors can be applied to the corporate bond market because corporations have equity and debt, and an investor can use some of the same metrics. However, because most of the bond’s return is driven by macroeconomics, the style factors have less of an influence.

Brooks concurred. “You have to get your credit and rates exposure right, but the most important decision as an investor is my strategic allocation,” he said.

One way to use factors in fixed income is to consider a systematic implementation of a fundamental idea, such as cheap securities outperform expensive securities. “We have a lot of evidence that is pervasive over time, persistent across asset classes,” he said.

For investors who want to use factors, Brooks said to start with the factor itself. In corporate bonds, for example, use the value factor, which is cheap bonds outperform expensive bonds, or the momentum factor, that bonds that are currently outperforming will continue to do so. Measuring the factor is important. For value, using publicly available bond information, such as the spread versus probability of default is one way.

One of the biggest challenges to widespread factor adoption in debt markets is that they’re all different—corporate bonds are different from mortgage-backed securities which are different from sovereign bonds, Tucker said, which makes it hard execute a strategy across the board.

Brooks said investors who want to hire managers who use factors in fixed income need to work with someone who has an expertise in how factor investing works, plus knowledge of fixed income and systematic trading.

“You may be trading in highly illiquid markets, in expensive markets. The limitations are paramount,” he said. “You need someone who can be involved in every single step of the process: how model, how execute, how to substitute [for another security] when you can’t get the bond you have in your model.”

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