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Applying factor investing to corporate bonds

Applying factor investing to corporate bonds

04-04-2018 | Insight

Although much factor research focuses on the equity market, the concept and benefits of factor investing apply equally well to the corporate bond market.

  • Patrick  Houweling
    Patrick
    Houweling
    Co-Head of Quant Fixed Income

Speed read

  • Increasing evidence to support factor investing in corporate bonds
  • Allocation to multiple factors reduces relative risk; enhancing factors improves performance
  • Multi-asset portfolios also benefit from allocation to bond factors

In their white paper ‘Factor investing in the investment grade and high yield corporate bond markets: an overview’, head of Quantitative Credits, Patrick Houweling and quantitative researcher Jeroen van Zundert show how factor investing can also be applied to the corporate bond markets and how systematically allocating to factors — size, quality, low risk, value and momentum – has been demonstrated to deliver higher risk adjusted-returns.

In the academic literature on corporate bonds, low risk and momentum are the best documented factors, while there has been far less research on quality, value and size. In their study, the Robeco authors define factors consistently with the existing literature. They use readily available bond characteristics (e.g. spread, rating, maturity) that are intuitive for corporate bond investors.

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Multi-factor portfolios offer more stable returns

Houweling and Van Zundert examine the risk-return profiles of both individual factors and a multi-factor portfolio. The single-factor portfolios each have their own distinctive risk return profile, while they all deliver higher risk-adjusted returns than the market index. The multi-factor portfolio offers diversification benefits that make the relative performance versus the index more stable over time. Their results show that the multi-factor portfolio retains the high Sharpe ratio generated by the individual factors, but with smaller drawdowns and a lower tracking error versus the market. They thus conclude that allocating to multiple factors is effective, both in the investment grade and high yield segments.

Having established the added value of factor investing in the corporate bond market, they move on to look at other asset classes too – equities and government bonds. Investors who already allocate their equity portfolio to factors may also be interested in extending this to approach to their corporate bond holdings. Houweling and Van Zundert’s results demonstrate that adopting a multi-factor approach in the corporate bond portion of a traditional multi-asset portfolio boosts its Sharpe ratio. While multi-asset investors who already allocate to equity factors and opt to allocate the corporate bond portion of their portfolio to factors too can improve their Sharpe ratio still further.

Enhanced factor investing

Robeco research has also shown that it is possible to improve on these academic results by enhancing the factor definitions and by enhancing the portfolio construction. In doing this, it is important to understand the latent risks in each factor and to mitigate those that are not properly rewarded with higher returns and to diversify across variables. This can be done by expanding the scope of these variables beyond bond market characteristics, for example, by also looking also at accounting and equity data. In terms of portfolio construction, performance can also be enhanced in a number of ways. By focusing on reducing turnover and keeping down transaction costs, by avoiding unintentional negative exposure to other factors in a single-factor portfolio and finally by preventing large sector and region bets to prevent concentrated positions and improve diversification.

Robeco offers single-factor and multi-factor strategies in investment grade and high yield that can be implemented as standalone solutions or incorporated in a multi-asset approach.

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