Distinguishing Factor Strategies in Corporate Bonds and Equities
Factor investing is becoming increasingly popular in the corporate bond market. Academic and practitioner evidence demonstrates that well-known equity factors can be redefined to capture excess returns in global corporate bond portfolios.
Dr Harald Henke
Head of Fixed Income Portfolio Management
New technologies and ever-increasing computing power allow quantitative fund managers to access large amounts of data necessary for the modelling of factors. This means that institutional investors can opt to invest in a different management approach for corporate bonds based on quantitative factor investing. In our new white paper, we answer a common question posed by asset owners: What distinguishes corporate bond factor strategies from equity factor strategies?
2020 – A markedly different year for equity and corporate bond factor strategies
In 2020, factor strategies regarding equities underperformed primarily due to the poor performance of the value style. Concurrently, factor performance in corporate bonds did well after an initial drop in March 2020, outperforming standard credit benchmarks by the end of the year. We investigated the commonalities and differences between the two asset classes and identified three areas in which there are significant differences.
Distinguishing Feature 1: Asset class complexity
Fixed income investing is multidimensional; for example, the corporate bond market is segregated across various segments such as credit rating (investment grade vs. high yield). This not only increases the complexity of the asset class, but also leads to inefficiencies in the market, causing mispricing in the credit universe. Owing to their systematic approach, factor strategies are well-positioned to exploit these inefficiencies.
Additionally, as the return distribution of credits is more asymmetric than that of equities, with the downside potential exceeding the upside by a wide margin, credit factor strategies must incorporate this feature by using factors that are defined to capture the asymmetry. The diverging level of complexity and efficiency makes it difficult to draw conclusions by comparing the performance and characteristics of different asset classes.
Distinguishing Feature 2: Factor definitions
The factor definitions in both asset classes measure different aspects. Value factors are defined by comparing the price of an asset against a fundamental value measure. However, there is a significant difference between equity value and credit value factors. In equities, value factors tend to be simple (e.g., selecting stocks according to their dividend yields). In contrast, for corporate bonds, we can estimate the expected loss of a bond with reasonable accuracy, which allows us to measure its fair value relative to its coupon and risk.
The momentum factor in credit is based on the issuer’s equity price. This factor works in credits because corporate bond prices react to new information slower as compared to stock prices. In equities, momentum compares the recent price performance across stocks, assuming that the trend will continue. Therefore, the mechanisms through which this factor works in each asset class are very different.
Distinguishing Feature 3: Market maturity
Finally, factor solutions for equities and bonds are at different levels of maturity. There are few active players competing for factor premia in corporate bonds, and these players do not share a consensus on the factors employed and how they are defined. Moreover, there are extremely few credit factor indices, most of which are ambiguously defined. The characteristics of these indices may not be suitable for the asset allocation of all investors, and there are limited passive solutions available, albeit with similar problems.
A future trend
Factor-based or style investing has a large footprint in equity portfolios with applications in active, passive, and smart beta strategies. However, factor-based investing is still in its infancy for fixed income. Studies indicate an increasing interest in factor strategies in recent years. This systematic approach in the asset class may experience increasing demand, providing a tailwind for experienced active-factor managers. Accordingly, we believe it would be prudent for asset owners to investigate factor investing in corporate bonds in more detail.
Read the full Quoniam – White Paper