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Factor-Based Investing in Fixed Income: A Case Study of the U.S. Investment-Grade Corporate Bond Market

Factor-based investing is a well-established concept in equities that has been supported by over four decades of research, testing, and documentation. However, factor-based investing in fixed income remains in its nascent stages. Recent studies have shown that the majority of fixed income active managers’ risk can be explained by systematic risk factors.

Our analysis finds that factor-based fixed income strategies implemented in a rules-based, transparent index can represent an alternative tool for fixed income portfolios. S&P DJI has examined a theoretical stylized example of a multi-factor index portfolio. This theoretical index portfolio attempted to reflect value and low-volatility factors existent in the U.S. investment-grade corporate bond universe.

EXECUTIVE SUMMARIES

  • As an increasing number of investors adopt risk-factor-based asset allocation, interest in smart beta fixed income strategies may be poised to grow.
  • Factors may be even more important in fixed income, as systematic risk constitutes a significant proportion of bond total risk.
  • Exposures to factors have long been utilized by active fixed income managers to achieve targeted risk/return characteristics. The majority of fixed income managers’ risk can be explained by exposures to factors.
  • Factors can be systematically reflected in a rules-based, transparent manner.
  • We seek to identify value and low-volatility factors in the U.S. investment-grade corporate bond universe.
  • Higher exposure to the value factor may be used to seek enhanced returns, while lower exposure to the low-volatility factor may be used to mitigate risk.
  • Back-tested results show that a multi-factor Index could maintain a target risk profile (ratings and duration) in line with the broad-based benchmark, while having the potential to provide higher risk-adjusted return.
  • High portfolio turnover remains a potential significant implementation challenge.

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