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Portfolio design

Fixed income factors

Jun 12, 2019
By Jeffrey Rosenberg, Tom Parker, CFA

We believe increased awareness of the role factors play in fixed income will help investors differentiate between return sources and seek the efficiencies they now experience in the equity portion of their portfolios.

Factors defined

Factor investing seeks to identify the broad, persistent drivers of return – factors – that have historically earned positive long-run results both across and within asset classes. Similar to equities, fixed income factors are grounded in economically sensible ideas that have historically delivered a premium because of one or more of the following drivers:1

  • Rewarded risk: Investors that have earned a long-term return in exchange for taking on a specific risk.
  • Structural impediments: Market rules or restrictions that have segmented the market or made parts of the market difficult for some investors to access, which can create opportunities for a subset of investors.
  • Behavioral biases: Not all investor decisions are perfectly rational, which creates opportunities for a contrarian view or to exploit existing trends.

As in equities, academic research has identified a number of factors that have persisted in fixed income markets. These can be divided into two general categories – macro and style factors:1

  1. Macro factors help explain risks and returns across asset classes. These are systematic, economy-wide sources of risk such as real rates and inflation.
  2. Style factors help explain risks and returns within asset classes. They are characteristics, such as value and momentum, which explain the outperformance of certain securities relative to other securities in the same asset class.
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Macro factors in fixed income

Over the long run, investors bearing exposure to macro factors are expected to be paid a premium because they are taking on a degree of risk. In general, macro factors help explain the vast majority of fixed income returns compared to style factors. Academic research further indicates that five principal macro factors have historically driven returns across fixed income securities:2

  • Real rates: The potential reward for taking on exposure to real interest rate changes. Rising real interest rates decrease the present value of future cash flows, and thereby the market value of fixed income securities.
  • Inflation: The potential reward for taking on exposure to changes in nominal prices and suffering erosion of buying power.
  • Credit: The potential reward for taking on the risk of an issuer default or spread widening.
  • Liquidity: The potential reward for taking on exposure to illiquid securities that are hard to trade and can experience extreme price losses in crisis conditions.
  • Emerging markets: The potential reward for taking on the risk of a government issuer default, spread widening or FX exposure. Political upheaval may lead a sovereign to change capital market rules or render it unable or unwilling to service debt.

Macro factors as fixed income portfolio building blocks

Decomposing typical fixed income instruments in the chart below can help illustrate how these macro factors may be the building blocks of asset classes. Importantly, this also demonstrates how factors can help explain each asset’s expected sources of return.

Through a factor lens, the traditional categorization of portfolio holdings along asset class labels — government bonds, corporates, emerging market bonds, etc. — is replaced with a categorization by overall factor mix.

For each asset class, the sum of these macro factor returns represents how it is expected to perform. For example, the return on a nominal government bond can be shown to derive primarily from three macro factor sources: inflation, real rates, and liquidity. Applying a factor lens, we would expect the total return of any given portfolio to be a function of its aggregate blend of macro factor exposures.

Conceptual macro factor decomposition of fixed income instruments

Chart showing conceptual macro factor decomposition of fixed income instruments.

Source: BlackRock. For illustrative purposes only. Size and magnitude of macro factors may vary overtime. Chart does not depict actual data.

A key implication for portfolio construction is that while a portfolio comprising numerous fixed income asset classes may appear diversified, it may in reality be deriving its risk and return from a few sources of concentrated and unintended macro factor bets.

For instance, the Bloomberg Barclays U.S. Aggregate Bond Index (“U.S. Aggregate”) comprises over 10,000 securities from six different bond sectors, making it one of the broadest fixed income benchmarks. However, when analyzing the index from a factor perspective in the chart below, the Bloomberg Barclays U.S. Aggregate Bond Index currently derives approximately 80% of its returns from interest-rate risk, which is a combination of the real rates and inflation macro factors.

Asset class and factor composition of Bloomberg Barclays U.S. Aggregate Bond Index

Chart showing asset class and factor composition of Bloomberg Barclays U.S. Aggregate Bond Index.

Source: BlackRock, and Bloomberg index data, as of 3/31/2019. Macro factor composition based on BlackRock Solutions’ Aladdin risk models as of 3/31/2019 and is subject to change.

Investors are already exposed to a mix of factors based on their asset allocation, although, in our view, those macro factor exposures are unlikely to be deliberate or carefully managed. However, by taking a macro factor perspective and looking beyond asset class labels to the fundamental drivers of return, we believe investors can gain a more precise way to manage portfolio risk. Thinking intentionally about the desired macro factor mix in the broader portfolio can help enable greater control and transparency when managing complex asset allocations, and help avoid unintended outcomes.

Style factors in fixed income

The second category of factors can be observed by examining securities within each fixed income asset class. Style factors help explain, for example, why one high-yield corporate bond outperforms another. This can help identify the factors that have persistently rewarded investors over the long run. We present below the four fixed income style factors that we believe are the most relevant for investors to consider:

  • Value: Cheap bonds (relative to fundamentals) that have historically outperformed expensive bonds.
  • Momentum: Bonds with strong recent performance that have historically maintained or reversed higher returns depending on where they lie on the credit risk spectrum.
  • Low volatility: Structural demand for higher-yielding bonds means stable bonds can potentially outperform more volatile bonds on a risk-adjusted basis, similar to the low-risk anomaly observed in equities.4
  • Quality: Bonds with a lower probability of default can potentially outperform bonds with a higher probability of default on a risk-adjusted basis.5

Empirical evidence of style factors in fixed income

Using the Bloomberg Barclays U.S. Corporate Bond Index as a proxy for the broad investment-grade corporate bond market, we demonstrate in the chart below how bonds with greater exposure to the four style factors have performed from a risk and return perspective versus those with lower factor exposure.

In these illustrative examples, we stratify the U.S. investment-grade corporate bond index into five quintiles based on exposure to a single style factor, with the fifth quintile (Q5) representing the highest exposure to the given factor, and the first quintile (Q1) representing the lowest exposure. For the sake of simplicity, we assign a set of metrics to represent each factor’s exposure. It is important to note that each quintile group is created on a sector- and rating-neutral basis to avoid any unintended tilts to a given credit quality or industry which could skew the results. Additionally, the returns, risk and Sharpe ratios shown for each quintile do not include transaction costs and are not representative of any particular investment strategy.

To measure the value style factor, we calculated the fair spread of a bond by taking into account duration, rating, sector, seniority, and issuer probability of default and then compared it to its market option-adjusted spread (OAS). To measure the momentum style factor, we used either the 3-month trailing spread return to calculate reversal or 6-month trailing spread return to calculate momentum depending on where a bond lies on the credit risk spectrum (calculated using issuer probability of default).

Bonds which have lower credit risk display short-term reversal and as we move towards higher credit risk, bonds display longer-term momentum. For the low volatility style factor, we used the duration-times-yield (DTY) statistic to proxy low volatility.3 To calculate the quality style factor, we used a BlackRock-developed, Merton-based probability-to-default model.

The analysis shows that in each of the four style factor examples, bond quintiles with a higher exposure to the given factor measure (Q5) produced higher excess returns per unit of risk (as measured by the Sharpe ratio) compared to those with lower factor exposure (Q1) and the overall market cap-weighted index.

Excess returns and Sharpe ratios of single style factors

Bar graphs showing excess returns and Sharpe ratios of single style factors.

The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Source: BlackRock, Bloomberg, using data from 2007-2018. Index represented by the Bloomberg Barclays U.S. Corporate Bond Index. Returns are shown as annualized returns above the duration-matched U.S. Treasury rate. Risk measured as annualized standard deviation. Index performance returns do not reflect any management fees, transaction costs or expenses.  Indices are unmanaged and one cannot invest directly in an index.

The key takeaway is that, as with equities, empirical evidence indicates that style factor exposures have played a key role in driving return differentials between constituents of the U.S. investment-grade corporate bond universe. We have conducted similar analysis in other parts of the fixed income markets, including U.S. high-yield corporates and European bond markets, and found similar evidence of style factors.

From a portfolio attribution perspective, we believe style factor contribution should be assessed as a long-term determinant of returns alongside other traditional dimensions such as sector, credit quality, and maturity.

Differentiating factors from alpha

It is common to think of alpha as analogous to excess returns above a specific market beta. However, we believe that alpha should be defined as returns in excess of market beta and factor returns—making alpha a much rarer commodity than the market presently assumes. Most traditional attribution frameworks may offer too simplistic a view of the return sources in a portfolio.

What is thought to be alpha resulting from idiosyncratic security selection decisions at a granular level, may actually be a long-term factor tilt towards a specific macro or style factor at the aggregate portfolio level.

We believe it is important to distinguish clearly between these sources of fixed income returns to help investors make better portfolio construction decisions.

Factor and alpha return sources

Image showing factor and alpha return sources.

Source: BlackRock. For illustrative purposes only.

Factors represent long-term exposures to broad and persistent sources of return that arise from risk premia, the existence of market structure impediments, and/or behavioral differences between market participants. Factors can be captured through transparent, rules-based strategies.

In contrast, alpha arises from an investment process designed to capture returns without persistent broad based market or factor exposures. We call this “pure” alpha, and by its nature is generally associated with idiosyncratic risks arising from both long and short security selection across asset classes to capture mispricing based on anticipated future market evolution or underappreciated historical developments. “Pure” alpha is the result of manager skill in security selection, country/industry selection, or tactical market and factor timing. Portfolio construction alongside execution and liquidity risk management also contribute to alpha.

Factors offer higher capacity, with opportunities for many investors to participate without the return source being arbitraged away or “crowded out.”  Alpha insights are typically more capacity constrained. Alpha is rare and hard to produce, making true alpha-generating strategies command higher fees than strategies that offer long-term exposures or static tilts to factors.

Tom Parker
CIO of Systematic Fixed Income
Tom Parker, CFA, Managing Director, is Chief Investment Officer of Systematic Fixed Income at BlackRock.
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Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, leads active and factor investments within the Systematic Fixed Income ("SFI") portfolio management team.
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