Default Risk Factor

Factor Investing in Bonds

Default Risk Factor

With stock investing, research by academics such as Eugene Fama and Kenneth French tells us that tilting portfolios to factors related to market cap size, valuations and profitability adds to returns over time. 

Such advances in modern portfolio theory have led to a rush by many investment advisors to find factors that can increase long-term returns in bond markets. Again, however, this isn't a new concept. In fact, Fama started exploring such dimensions to bond investing in the 1970s. 

Along these lines, our investment committee is impressed with a series of research reports into factor-based portfolio management by Dimensional Fund Advisors. 

In a more recent example of its work in this area, four Dimensional researchers have taken a look at several factors that some believe could deliver a premium to investors in corporate bonds. (You can read the full report, "The Cross-Section of Corporate Bond Returns," by clicking here.) 

To review this research and put it into perspective of a wider body of evidence on factor investing in fixed-income, IFA talked to several veteran Dimensional authorities on the topic. Below is a Q&A interview with two of those experts we consider as particularly knowledgeable in the field. 

One is Dave Plecha, who is Dimensional's global head of fixed income. Included in this discussion is Wes Crill, a senior Dimensional researcher. 

IFA: What is the primary factor that drives longer-term returns in fixed income? 

Crill: As studied by Dimensional, in the cross-section of corporate bond research, forward rates stand out as the most reliable and the most useful metric for targeting bonds with higher expected returns.  

IFA: What are forward rates?

Crill: Forward rates are the sum of a bond's yield and expected capital appreciation. These can be calculated from current market prices and provide a good estimate of expected bond returns. At Dimensional, we've been using forward rates to manage systematic fixed income strategies for more than 30 years. 

IFA: How do you apply forward rates to managing bond portfolios?

Crill: Forward rates contain reliable information about expected bond returns. Using this information allows us to systematically target higher expected returns in our fixed income strategies. Specifically, we calculate forward rates on a daily basis across multiple yield curves to determine which yield curves and which durations on each curve offer the highest expected returns. We then use our expertise in implementation to keep a strategy focused on those higher expected return areas of the market, while continuously managing tradeoffs between higher expected returns, risks and costs.  

IFA: How does this information relate to expected returns and managing a bond portfolio?

Plecha: We manage fixed income portfolios from the starting point that you don't have to outguess the market. Our starting point is current price. From current bond prices, we can solve for yields and ultimately forward rates.  

IFA: Can you give me an example how you would project expected returns?

Plecha: If we know the price of the bond and its coupon rate, that allows us to solve essentially for its internal rate of return, which we all know as its yield to maturity. If, for example, you buy a three-year corporate bond and plan to sell it in a year, you could then look for bonds from the same issuer that are currently two years to maturity and observe their current yield. This provides us with the necessary data to estimate what that three-year bond's expected return would be over the next year.   

IFA: What are some of the other factors you've studied in fixed income? 

Crill: A recent comprehensive study led by my colleague Philipp Meyer-Brauns, looked at 14 variables -- including bond-level characteristics such as default-adjusted credit spreads (value) and past short-term bond returns, as well as characteristics related to the bond's issuer such as the issuer's market capitalization (size) and issuer's past short-term equity returns. 

IFA: What does this type of research show you in the aggregate?

Crill: The study confirmed that forward rates are strongly related to expected returns -- we know that from both empirical as well as theoretical studies. So, the real question is: do other variables, which some have proposed to be related to bond returns, provide additional information that goes above and beyond forward rates?

IFA: What've you found about other variables in fixed income investing?

Crill: We find that most variables are not reliably linked to differences in bond returns, or they provide information about expected bond returns only through their correlation with forward rates. Essentially, many of the metrics that have been cited by others as predictive of expected bond returns aren't telling us much new. 

IFA: Specifically, what are some of these factor variables we're talking about as not providing significant amounts of added information beyond forward rates?

Crill: We looked at a number of characteristics related to the issuer's equity, including: market capitalization, book-to-market ratio and profitability. Other issuer-level characteristics we assessed included: leverage, distance-to-default and equity momentum. We also studied bond-level metrics such as bond momentum or a bond's default-adjusted credit spread, which has been linked to value investing in corporate bonds. 

IFA: In other words, none of these showed meaningful relation to corporate bond returns once corrected for forward rates?

Crill: That's correct, with one exception. 

IFA: So that gets back to the lone exception, right?

Crill: Yes, that exception is the short-term equity return of the bond's issuer. This measure is the issuer's stock return over the past month. Our research shows that if a company's stock does poorly, its bonds tend to have relative underperformance in the next month. Conversely, if a company's stock does well relative to peers, its bonds tend to outperform in the next month.  

IFA: How does Dimensional account for this finding?

Plecha: Dimensional accounts for this through our normal trading and credit monitoring process. The bond desk has always looked at the stock price before buying the bond. Interestingly, it wasn't until 2002 that broker-dealers were required by regulators to publicly report bond transactions -- allowing us to directly observe bond prices. Equity markets had been publicly reporting prices for a long, long time. So, it's always been in our DNA to check stock prices before trading corporate bonds. 

IFA: How does this process work?

Plecha: For example, if you see a sharp drop in the price of a particular stock, we've observed that it may also lead to bond traders selling the same company's bonds as well. As a result, when we see a sharp decline in a specific stock's price on any given day, we find it prudent to temporarily avoid buying a bond issued by that same company until things settle down. 

IFA: The cross-section of Dimensional's corporate bond research supports such qualitative views, doesn't it?

Plecha: Yes, this research has helped us to formalize and quantify that characteristic as a factor to consider in managing bond portfolios, which again was something we'd been doing on a qualitative level for years. The important point here is that while a company's stock price activity might provide us with relevant information about what not to trade on a particular day, it doesn't help us to make decisions on what to trade. 

Crill: That's a key finding of our research -- short-term equity return is an additional data point. But this information is best used as a supplement to what forward rates tell us. 

Plecha: Yes, short-term equity momentum helps us to whittle down our list of bonds we might like to buy on any given day. We might go into a day with a number of bonds we'd like to purchase. If a particular stock tanks, however, the short-term equity momentum characteristic might suggest we'd be better off waiting. Again, this isn't a market-timing call. We're just trying to make best use of any information supplied to us by this equity factor we've found in bonds. 

IFA: In a nutshell, you see forward rates as the best indicator of what bonds to buy or sell, but a company's stock return might be worth considering in terms of exactly when to execute a trade?

Plecha: Yes, this is the value of Dimensional's implementation. It allows for flexibility in implementing the strategy at the moment of the trade. For example, monitoring short-term equity returns may help whittle down our list of bonds we might like to buy on any given day. If a particular stock has had a recent sharp decline in price, it might suggest we'd be better off waiting to buy that bond. This isn't a market-timing call. We're making the best use of the information in security prices to fight for every basis point in our fixed income portfolios. 


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