PORTFOLIO DESIGN

Fixed income style factors: Moving from theory to practice

Oct 15, 2020
  • Scott Radell
  • Tom Parker, CFA

The combination of low yields and more challenging conditions for active managers may have investors looking for new ideas in fixed income markets. Explore how a style factor-based approach to US corporate bonds may potentially generate improved absolute and risk-adjusted returns.

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Style investing in fixed income

Equity and fixed income investors alike have often strived to discern the drivers of investment returns. Over time, clear and persistent drivers of returns—known as “factors”—have been identified.  BlackRock’s research has shown that the core principle of factor investing—systematically identifying and capturing persistent risk premia—also applies to bond markets.

Style factors help explain differences in risks and returns within asset classes. Historically, style factors represent characteristics, such as quality and value, which may determine, for example, why one group of corporate bonds may have outperformed another.1

BlackRock has identified a broad set of fixed income style factors grounded in intuitive, fundamental investment concepts. The figure below provides an overview of the four principal style factors—quality, value, momentum, and low volatility—that we believe have the most application for investors.

Overview of fixed income style factors

Overview of Fixed Income Style Factors

Source: BlackRock. Based on the opinions of the Systematic Fixed Income Group as of October 2020. Forecasts are based on estimates and assumptions, there is no guarantee that they will be achieved. The information shown above is for illustrative purposes only and not meant to be a recommendation to buy or sell any security.

Style factor application: Reach for Safety NOT Yield

Today’s low yield environment has made it challenging to generate income and total returns while managing corporate bond risk. Investors are often forced to reach for yield and take on more risk to meet return and income targets—further bidding up the prices of the riskiest securities. While reaching for yield may work in upward trending markets, avoiding defaults when the credit cycle turns downward is extremely important to maximize total return in the long run. Consider an alternative approach to investing in US corporate bonds that reaches for safety—not yield.

Implementing style factors in US corporate bond portfolios

A “reach for safety” approach to credit investing blends the characteristics of two diversifying2 style factors—quality and value—into a single portfolio that seeks to minimize the drawbacks of reach for yield portfolios.

First, a quality factor screen can be used to remove riskier securities that have a higher probability of default. Intuitively, we believe removing such securities may help provide downside mitigation and avoid the behavioral bias of chasing yield in riskier securities. Second, a value factor tilt can be used to favor bonds that appear to be underpriced relative to fundamentals. Value is a historically rewarded risk factor which seeks to identify bonds that are inexpensive relative to their financial strength.3

Blended style factor portfolio construction process

Style Factor Portfolio Construction Process

Source: BlackRock. Investment process is shown for illustrative purposes only and is subject to change.

Such an approach allows for the screening of riskier, overvalued exposures while simultaneously seeking to preserve market context yields and improve total return potential with less cyclicality.

Moving from factor theory to portfolio practice

This style factor framework has been developed into a set of rules-based credit indices through the BlackRock Investment Grade Enhanced Bond Index and the BlackRock High Yield Defensive Bond Index.

These indices may provide opportunities to meet a mix of client objectives such as higher total returns, lower volatility and superior risk-adjusted returns versus market-capitalization-weighted allocations. Although the current live track record for these indices is only three years long, we believe the current results and the future of fixed income style factor investing are promising.

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KEY TAKEAWAYS
01

The fundamental investment concepts underlying style investing in equities can also be applied to fixed income markets.

02

Style factors can help explain the historical differences in risk and return among a universe of US corporate bonds.

03

Style factors, such as value and quality, can be integrated into a US corporate bond portfolio to pursue improved absolute and risk-adjusted returns over a market index.

Tom Parker, CFA
CIO of Systematic Fixed Income
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Scott Radell
Head of Core Portfolio Management, Systematic Fixed Income
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