How factors may help bond investors reach their goals

The quality and value factors may help investors target specific risk and return objectives

Aug 8, 2018 | Invesco Fixed Income

In recent years, factor-based investments have become increasingly popular for equity investors. Often missing from the discussion, however, is the concept of fixed income factor strategies. At Invesco Fixed Income, our view is that bond investors can potentially benefit from a factor-based approach. We’ve launched a new suite of exchange-traded funds focused on two factors — quality and value — that we believe may help investors reach their objectives.

What are fixed income factors? 

At its core, factor investing is an investment strategy in which securities are chosen based on specific characteristics and attributes.

  • The quality factor is typically implemented by holding low-volatility bonds. These are typically shorter-maturity bonds with relatively low default risk, as measured by their credit ratings.
  • The value factor is derived from holding bonds priced at a discount to similar securities. Since a bond’s price is a function of its default risk, it makes sense to look for bonds that are priced at a discount relative to their implied default rates

Factors differ from traditional fixed income classifications like maturity, credit rating and industry. Instead of focusing on a bond’s outward characteristics, fixed income factors are distinguished by their potential to generate excess returns and other investment outcomes across multiple market cycles. 

Because fixed income investors have unique goals, we believe it’s important that investors have a choice between single-factor and multi-factor portfolios. For example, the value factor offers investors income and capital appreciation potential, while the quality factor may provide capital preservation. Combined, these factors may help provide a combination of all three objectives. And because many factors have unrelated return patterns or correlations, a multi-factor approach offers the benefits of diversification, which can mitigate risk and help to provide higher risk-adjusted returns over time.

Potential benefits of fixed income factors

In our view, there are three reasons why fixed income factors may generate excess returns:

  • Factors may generate excess returns as compensation for investors assuming more risk.
  • Factor investing may help to address the behavioral biases that can lead to sub-optimal decision-making and can create long-term drags on performance.
  • Excess returns may result from inefficient use of capital. For example, many institutional investors are prohibited from owning so-called “fallen angels” — bonds that have fallen out of favor or have seen their credit ratings cut. Excess selling around the time of a bond’s downgrade can lower valuations, which may create excess return potential.

Differences between equity and fixed income factors 

In our view, fixed income factor strategies should be constructed differently than their equity counterparts. This is because fixed income investing is largely viewed as a means to potentially help conserve capital. In addition, fixed income securities are difficult to sell short and have higher transaction costs and less liquidity than equities. Because only slightly more than half of the fixed income securities desired for factor inclusion are available for trading, investors need to have confidence that there is enough bond liquidity for factor portfolios to be constructed. That requires a different kind of strategy.

Invesco’s approach to fixed income factor investing 

We believe that fixed income factors must first have a strong rationale that is deeply rooted in economic theory. While back-testing may produce compelling results over selected time periods, that isn’t enough to justify a factor-based strategy; factors must also be robust across multiple market regimes. To accomplish this, we believe it’s paramount that factors offer a tradeoff between risk and return. In our view, the most consistent, enduring factors are those that have the potential to offer excess returns in exchange for risk.

Invesco Fixed Income takes a precise approach to factor investing. Because the goal of fixed income investing can involve capital preservation, income generation, capital appreciation or some combination of all three, we believe it’s important to provide investment strategies that are appropriate for each investor’s financial objectives.

We expect fixed income factor investing to take on increased importance in the coming years. But factor strategies are dynamic and require continuous research. As market environments change and investor needs evolve, so, too, must factor strategies. By adapting to structural market changes and the increasingly sophisticated expectations of investors, we believe fixed income factors will serve as critical components of outcome-oriented investment strategies.

 

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