Factor-based investing arrives for fixed income

Factor investing for fixed income is coming of age for money managers as they anticipate a rise in investors searching for new ways of eking out yield from challenging bond markets.

Executives at money management firms and consultants said they are becoming increasingly aware of the idea of bringing factors into fixed income — partly due to the market backdrop and also as they become more comfortable with the use of multifactor strategies for equities. But some said institutional investors are not quite up to speed, and sources said there are a number of important considerations for investors and managers, including the availability of data and how to apply multiple factors such as value and volatility to bonds.

"Although we have witnessed little demand for factor-based strategies from our client base, we have noted an uptick in asset managers promoting these products," said Paul Cavalier, global head of Mercer's fixed-income boutique in London. While the concept of factor investing for equities has been "embraced for several years," for fixed-income it is a different story.

"There are certain strategies that we have seen, we like, have rated and are putting in front of clients," said Kate Hollis, senior investment consultant at Willis Towers Watson in London. "But people are not knocking on the door saying 'give me multifactor fixed income' in the same way as (they are regarding) emerging markets debt, for example. ... It is complex, and the level of understanding and appreciation of how the strategies could and should be used is much lower."

If recent research by Invesco is ​ anything to go by, client demand will be on the rise. The firm's latest Global Factor Investing Study showed that while 68% of those surveyed believe the theory of factor investing can be applied to fixed income, 32% make use of the strategy in their portfolios.

"Right now many of the institutional investors already comfortable with equity factor strategies are actively looking to allocate into fixed-income factors," said Jay Raol, Atlanta-based senior macro analyst at Invesco Fixed Interest. Interest is global, and the firm sees particularly high demand for credit factors in Europe, Middle East and Africa and duration or foreign exchange exposure in Asia.

Other managers agree. "Factor investing in fixed income is a more recent development than it is in equities, but the take-up has been more rapid," said Peter Walsh, London-based head of Robeco U.K. "The foundations had already been laid and for structural reasons, the implementation is more straightforward."

Managers define the strategy in different ways: some refer to it as factor investing, some call it systematic and some say it is a subset of smart beta.

Amundi's Laurent Trottier, Paris-based global head of ETF, indexing and smart beta management, said the firm is "seeing demand for smart beta in fixed income, and this is coming (largely) from investors that have already made the switch on the equities side … either to reduce risk or to increase return or for both."

Lombard Odier Investment Managers runs systematic rule-based fixed-income investing, which can also be assessed through a factor-investing lens, said Salman Ahmed, chief investment strategist in London. The firm's divergence from traditional market-cap-weighted fixed-income investing is based on "default risk mitigation," he said, adding that interest is coming from central banks and pension funds in Europe and Asia.

The status quo is market cap-weighted indexes for fixed income, said Mr. Ahmed, which is "quite perverse" given increased exposure to more indebted companies. "The argument has never been tested or challenged massively — we have been in a bull market for a long period of time. And let's not forget — market cap has one big advantage … it is transparent and easy to understand."

However the managers define the idea, they agree that a number of factors in the fixed-income market have the potential to change the status quo.

Brett Pybus, head of iShares EMEA fixed-income product strategy in London, said client interest in factor or smart beta strategies in fixed income "is increasing as investors place greater emphasis on identifying drivers of risk and return in order to meet specific outcomes."

Mr. Pybus said increased institutional focus is partly a natural extension of equity factor investing and also the market backdrop. "Low yields and concerns about specific risks in fixed-income markets, most notably interest rate risk, are leading investors to analyze the risk drivers behind benchmarks more carefully, and seek to construct portfolios accordingly." He cited the example of adding spread risk to a portfolio through allocations to assets such as corporate bonds, while reducing or hedging interest rate risk. The firm has launched a number of exchange-traded funds that seek exposure to specific macro or style factors in fixed-income markets.

Despite managers' enthusiasm for the strategy, barriers to entry remain relatively high compared with equities — it is not simply a case of copying and pasting that structure.

"The challenges to implementing systematic strategies in fixed income (are) data and liquidity," said Scott Richardson, London-based principal at AQR, which offers systematic fixed-income strategies. "First, a systematic investment process requires access to a broad set of market and fundamental data that is accurately mapped across the assets you wish to trade (in this case bonds) and the issuing entity."

A particular challenge on the corporate securities side is "gaining access to reliable and well-mapped data," he said.

Ms. Hollis agreed. "This type of research in equities is much easier because there are a lot of academics, data is available and easy to source and equities are of the same duration, and therefore much easier to analyze." For fixed income, security-level data is expensive to source, adjustments are necessary for duration of bonds and there is a greater need to build in transaction costs. "It is extremely complicated," she said.

While the factors used in equities — quality, value, carry, momentum and size — are the obvious candidates, they need defining differently to apply to fixed income. "But what the managers are looking at are ways of systematically replacing what active managers have done for years. The question is how you adapt the factor for the asset class so it makes sense," added Ms. Hollis.

There are also certain parts of credit markets for which factor-based investing will not necessarily work. "We do not apply (this approach) on emerging markets, and we do not think it would be a good idea to tackle emerging markets in such a way, because that would be blind to what is driving the markets in terms of politics," said Etienne Vincent, Paris-based head of global quantitative management at BNP Paribas Asset Management.

And Mercer's Mr. Cavalier warned that despite the increase in computing power and data gathering that has led to models that use factors similar to quantitative equity techniques, "we are currently witnessing a new environment in bond investing, extreme low yields and tight credit spreads, (and) it is difficult to assess, or even model, the impact of these different return drivers when this environment begins to unwind."