ANDREW’S ANGLE

The Next Factor Revolution: Fixed Income Factor ETFs

Oct 26, 2022

Historically, investors were faced with a choice when deciding how to build their fixed income portfolios. Do they value the transparency and lower cost of a fixed income ETF? Or do they want to hire an active manager to aim to outperform? Fortunately, advances in technology now mean investors can now target the same drivers of return used by active managers but do so in a rules-based ETF. Equity investors have been using factor ETFs for years. Today, fixed Income factor ETFs are providing investors control over the factor exposures in their bond portfolios.

I was hooked from the beginning. My parents brought me and my brother to the drive in, we got to stay up way past our bedtime and saw Star Wars: Episode IV – A New Hope. A lot of light saber battles in the garden followed. As big a success that Star Wars was, it was followed by something that blew my mind—a sequel that was earth-shattering in its reveal that Darth Vader is Luke Skywalker’s father, an edge-of-the-seat cliffhanger (what’s going to happen to Han Solo frozen in carbonite?)—the sequel The Empire Strikes Back made those events a long time ago in a galaxy far, far away real to me.

I can’t help but be reminded of Star Wars and all of the sequels that came afterwards (Baby Yoda is awfully cute on the Mandalorian, don’t you agree?) when I think about our iShares credit factor ETFs: IGEB (the iShares Investment Grade Bond Factor ETF) and HYDB (the iShares High Yield Bond Factor ETF).

Factor investing is a powerful approach that enables investors to target well-established sources of return in an attempt to outperform the broad market. These broad and persistently rewarded drivers of return are intuitive—like buying cheap securities (value factor) and securities of issuers that tend to have more steady earnings (quality factor). Factors are backed by six Nobel prizes and hundreds of years of empirical data. It’s no surprise that factor investing has exploded in equity markets.

At the same time, investors have also been adopting fixed income ETFs as they realize the benefits of gaining fixed income exposure through a fund that trades on an exchange, providing an easier and more efficient way to build well-diversified bond portfolios.

Individually, these are two popular segments in asset management—factors and fixed income ETFs. Together, they form a powerful tool, allowing fixed income investors to target excess return in a rules-based index delivered in a low-cost, transparent ETF.

Security Selection

Active managers often attempt to outperform the credit markets 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.1 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 high yield bonds have experienced higher levels of volatility while delivering disappointing total return.

Chart graph1

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 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.

We believe this provides an opportunity for improved security selection by using a quality factor screen to remove riskier securities. Starting with a broad investable universe, lower quality bonds (i.e., those with the highest probability of default) within each credit tier are screened from the portfolio. The systematic process leverages BlackRock’s probability of default model, which employs a full balance sheet approach to assess credit quality based on accounting statements, market data of both equity and bond instruments, bond ratings, and other economic variables to estimate the probability of default for the issuer over the next twelve-month period.

A portfolio consisting solely of the remaining high-quality bonds would likely be very defensive, but also quite cyclical. Furthermore, screening out the riskiest credits may reduce the portfolio’s yield, creating a performance headwind. To mitigate this, one might apply a value tilt within the remaining portfolio of bonds, favoring issues that are inexpensive relative to their current fundamentals and future prospects. The resulting portfolio detailed above would pair two diversifying factors (quality and value) in order to seek improved total return potential with less cyclicality.

A history of consistent outperformance

Launched in 2017, the funds have been steadily building track records of success. As of August 31, 2022, IGEB had outpaced the Bloomberg U.S. Corporate Bond Index by 0.43% over the trailing five-year period on an annualized basis, ranking in the 12th percentile in the Morningstar US Fund Corporate Bond category and earning the fund a 4-star rating.2 Over that same period, HYDB generated 0.58% in annual excess return over the Bloomberg U.S. High Yield Index, also ranking in the 12th percentile in the Morningstar US Fund High Yield category. HYDB was rewarded with a 4-star rating.3 For details regarding Morningstar’s ratings methodology, please consult disclosure below.

While this is impressive, the true selling point of the funds is the consistency of their outperformance. As the charts below illustrate, IGEB has topped the Bloomberg U.S. Corporate Bond Index in 70% of rolling 12-month periods since inception, with an average excess return of 61bp. Relative to the Bloomberg High Yield Corporate Index, HYDB has outperformed in 66% of 12-month periods, generating an average of 44bp in excess return. Over the past three years, IGEB delivered 77bp of excess return while HYDB exhibited an average annual excess return of 53bp.

Chart graph2
Chart graph3

Source: BlackRock, Morningstar as of 8/31/22. For IGEB, excess return represents 12-month rolling returns of the IGEB ETF minus 12-month rolling returns of the Bloomberg U.S. Corporate Index. For HYDB, excess return represents 12-month rolling returns of the HYDB ETF minus 12-month rolling returns of the Bloomberg High Yield Corporate Index. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance and standardized performance, click here.

The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. IGEB received a rating of 4 stars for the 3-year period, 4 stars for the 5-year period and -- stars for the 10-year period, rated against 185, 165 and 95 Corporate Bond funds, respectively. IGEB ranked 26th over the 3-year period, 14th over the 5-year period, and ranked -- over the 10-year period. HYDB received a rating of 4 stars for the 3-year period, 4 stars for the 5-year period and -- stars for the 10-year period, rated against 626, 579 and 398 High Yield Bond funds, respectively. IGEB ranked 29th over the 3-year period, 14th over the 5-year period and ranked -- over for the 10-year period. These ratings are based on risk-adjusted returns. Past performance does not guarantee future results.

Expanding factors into fixed income ETFs

Factors in equities is the original Star Wars. It was new and revolutionary with an iconic villain, Darth Vader, who (plot spoiler coming…) later becomes good, and started a cultural phenomenon. Like Star Wars, factors in equities is just the first act. Pushing the same broad and persistent drivers of return in fixed income, like harvesting quality and value factors with fixed income ETFs, is The Empire Strikes Back. 

These types of funds can be a powerful addition to your portfolio, whether you are a seasoned equity factor investor looking to expand that approach into fixed income, or a traditional fixed income investor interested in harnessing the power of factor investing to target excess returns that active bond managers have used for decades. With fixed income factor ETFs, investors have access to the same benefits in bond markets that investors have experienced with factors in equities—seeking excess return at lower fees with greater transparency and tax efficiency.