Andrew's Angle

The Next Frontier: Factor Investing in Fixed Income

Oct 29, 2021

The capacity of factor strategies appears large 

Often the best advances in technology are those that enable us to do everyday tasks easier and more efficiently. Today, my phone is not just a phone but gives me messages, chats, photos and videos, maps, games, email, allows me to book cars and order food, and gives me directions. All of those underlying things are still the same, but my phone has changed my life in bundling all these technologies in a convenient package. New factor fixed income ETFs are the mobile phones of bond investing, delivering well-known, historically rewarded macro and style sources of returns more efficiently, transparently, and at much lower cost.

Occasionally, I use my phone as a phone. But more often, I watch movies and TV series (I’m working my way through Friday Night Lights), play games (my current favorite is Plants vs Zombies, or PvZ) do email, read the news, do my banking, listen to music, get directions, order stuff for delivery, plan travel, and take photos and videos of my family. The underlying things are the same—maps, newspapers, email, banks, etc—but the bundle of all of those services on one convenient device has changed my life.

Factor exchange-traded funds (ETFs) are the mobile phones of investing. They take well-known, historically broad and persistent sources of returns—like value, quality, minimum volatility, and momentum—and packages them together in convenient ETFs, transparently and at low cost, making available active management insights to every investor. Not surprisingly, equity factor ETFs have gained wide acceptance, with several funds topping $20 billion in AUM while the US industry total is well over $600 billion and significantly more than $1 trillion globally.1

The next frontier is applying factors in fixed income. Similar to equities, we can seek superior risk-adjusted returns at a reasonable fee and the ETF structure provides investors with tax efficiency. But there is even greater potential opportunity for factors in fixed income because bonds have been even more exposed to the broad and persistent sources of returns—macro and style factors—than equities. Many of the traditional sources of returns of outperformance of active bond managers are well known: credit and duration tilts, security selection, and pro-active positioning of bond portfolios in different economic conditions. In fact, these sources of return have led many of the largest core fixed income active managers to consistently outperform the Bloomberg U.S. Aggregate Bond Index.2 What’s different today is that we can package these active manager insights in new factor fixed income ETFs, just like our mobile devices bundle different apps.

Strategically target attractive segments of the bond market

One potential source of outperformance in fixed income is to strategically target segments of the market that may deliver attractive risk-adjusted returns. An example of this in the corporate bond market is fallen angels; formerly investment-grade-rated bonds that have recently been downgraded to high yield status. The chart below compares the 1-year trailing return difference between the Fallen Angel Index and the broad High Yield Index. Over sustained periods of time, fallen angels have shown periods of outperformance—sometimes double digits—with relatively similar volatility as high yield bonds.

Trailing 1-Year Return Difference

Return Difference

Source: Bloomberg as of 9/30/2021. Bloomberg US High Yield Fallen Angel 3% Capped Bond Index vs Bloomberg US High Yield Corporate Bond Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual Fund performance. For actual fund performance, please visit www.iShares.com.

Clearly this strategy aims to provide an active-like outcome, benefitting from price rebounds in recently downgraded bonds that are more likely to return to investment grade. However, this sophisticated strategy is indeed systematic, and can be accessed in a lower-fee, rules-based manner through FALN, the iShares Fallen Angels USD Bond ETF.

Security selection

Fixed income active managers can also outperform the market by selecting better-performing bonds. Research has shown that some managers reach for yield, causing the riskiest bonds within each credit rating to be bid up, and thus have low average returns.3 Furthermore, investors may be severely penalized in down markets when these securities reprice, are downgraded, or eventually default. The following chart demonstrates that the lowest quality bonds have experienced higher levels of volatility while delivering disappointing total return.

Ratio

The figure shown relates to past performance. Past performance is not a reliable indicator of current or future results. Source: BlackRock, ICE BofA Indices, Bloomberg. Based on the ICE BofA US High Yield Index from 1 January 2004 to 30 June 2020. The plots show the historical performance of market value-weighted quintile portfolios (Q1 to Q5) that measures the Quality (distance to default) for high yield bonds. Yield referenced is yield to worst (YTW) while volatility represents standard deviation of monthly returns. Standard deviation measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. Sharpe ratios are reported for the quintile portfolios. The Sharpe ratio characterizes how well the return of a portfolio compensates the investor for the risk taken. The higher the Sharpe ratio, the better a portfolio’s historical risk-adjusted returns have been. Index returns are shown for illustrative purposes only. It is not possible to invest directly in an index.

This provides an opportunity for better security selection by using a quality factor screen to remove riskier securities (i.e. those that have a higher probability of default) and a value factor tilt to favor bonds that appear to be underpriced relative to fundamentals. The pairing of these two factors seeks to improve total return potential with less cyclicality. Investors seeking to enhance returns and mitigate risk within investment grade credit may consider IGEB, the iShares Investment Grade Bond Factor ETF, while high yield investors can access these strategies in HYDB, the iShares High Yield Bond Factor ETF.

Tactically timing risk environment

Many active managers seek to add value by timing a fund’s exposures to interest rates and credit risk based on their outlook on the business cycle. We can target a similar outcome using a systematic approach, using market information on bond prices and credit spreads. This gives us insight into an issue’s expected loss should a default occur. We can then aggregate this information to the expected loss at the index level. Periods with low expected loss would be considered risk-on, while high expected loss periods would be risk-off. We can further refine this by examining spread momentum, or the level of current spreads versus their recent history. Positive momentum implies improving credit conditions, while negative momentum suggests that credit is deteriorating. The combination of these signals allows us to determine risk regimes ranging from 1) very risk-on, 2) risk-on with improving credit, 3) risk-off with deteriorating credit, and 4) very risk-off.

Market regime Interest rate risk as % of market Credit Spread risk as % of market

RISK ON

  • Increase allocation to tactical, aggressive assets
  • Reduce allocation to core, defensive assets
Lower Higher

RISK OFF

  • Reduce allocation to tactical, aggressive assets
  • Increase allocation to core, defensive assets
Higher Lower

Source: BlackRock as of September 30, 2021. Hypothetical for illustrative purposes only. Interest rate risk refers to the target option adjusted duration of the index relative to the universe. Credit spread risk refers to the target duration times spread (DTS) relative to the universe.

All of this was considered when designing the BlackRock USD Bond Factor Index, which seeks to deliver superior risk-adjusted returns relative to the Bloomberg U.S. Aggregate Bond Index and can be accessed with the recently launched iShares USD Bond Factor ETF (USBF), which seeks to track the index. During risk-off months, the index aims for less credit exposure while adding duration to capitalize on the potential for falling interest rates. In a risk-on environment the index seeks to take on more credit exposure while shortening its duration. The index tactically adjusts credit and interest rate exposure based on the current risk regime, while also strategically targeting the attractive segments of the Treasury and corporate bond markets, and uses value and quality screens to drive security selection.

Fixed Income Factor ETFs

I believe equity factor ETFs have thrived for three reasons: greater efficiency, lower fees, and transparency. The ETF also enables greater tax efficiency. The same proposition is true for fixed income factor ETFs. These can change fixed income investing, just like our mobile phones have empowered our lives, by bringing together different sources of potential return in one convenient package.

Andrew Ang
Andrew Ang
Head of BlackRock Systematic Wealth Solutions and Head of the Factor-Based Strategies Group
Andrew Ang, PhD, Managing Director, is Head of BlackRock Systematic Wealth Solutions and Head of the Factor-Based Strategies Group. He also serves as Senior Advisor to ...
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