Since Eugene Fama and Kenneth French’s 1992 publication of the paper “The Cross-Section of Expected Stock Returns,” factor-based (style) investing has been applied in equity markets. Not only has it become increasingly popular, with massive flows into “smart beta” products, it has also been extended to long/short, market-neutral applications and across bonds, currencies and commodities.
Despite style investing’s popularity, comparatively little has appeared in the literature, or been put into practice by publicly available funds, as it relates to the enormous bond markets.
Jordan Brooks, Diogo Palhares and Scott Richardson of AQR Capital Management add to our understanding in this area with the study “Style Investing in Fixed Income,” which will appear in a forthcoming issue of the Journal of Portfolio Management. They applied the value, momentum, carry and defensive style premiums to country and maturity selection across global government bond markets and to individual issuer selection across U.S. investment-grade and high-yield corporate credits.
Value is the tendency for relatively cheap assets to outperform relatively expensive assets. To determine value, the authors measured market “prices” as yields in the case of government bonds and as credit spreads in the case of corporate bonds.
For government bonds, they used a “real yield” metric, comparing nominal yields against maturity-matched inflation expectations from survey-based forecasts from Consensus Economics. Government bonds with higher (lower) real yields relative to their peers are cheap (expensive).
For corporate bonds, they compared credit-option-adjusted spreads against two fundamental anchors designed to capture the “risk” that the company may migrate to a poorer credit quality.
The first fundamental anchor is a structural model that measures the bond’s “distance to default,” which reflects the number of standard deviations the asset value is away from the default threshold. The second fundamental anchor is an empirical model based on a regression of the spread on duration, rating and return volatility. In both cases, a corporate bond is deemed cheap (expensive) when the credit spread is high (low) relative to the respective fundamental anchor.
Momentum is the tendency for an asset’s recent performance to continue in the near future. For government bonds, Brooks, Palhares and Richardson used the prior 12-month excess return. For corporate bonds, they used an equal-weighted combination of the bond’s prior six-month credit excess returns and, for public issuers, the bond’s prior 12-month returns. While the results were not sensitive to the choice of lagged 12-month excess credit returns, the authors chose the prior six-month period to increase data coverage.
Carry is the tendency for higher-yielding assets to outperform lower-yielding assets. It assumes a return if relative prices do not change.
Defensive (quality) is the tendency of safer, lower-risk assets to deliver higher risk-adjusted returns than their low-quality, higher-risk counterparts. For government bonds, within each country, the authors’ position goes long short-dated bonds and shorts a duration-equivalent amount of long-dated bonds. For corporate bonds, they also favor low duration, but include two additional indicators based on profitability (gross profits over assets) and leverage (measured by the ratio of net debt to the sum of net debt and market equity).