How should investors gain access to the return premia offered by the bond markets?
Traditional options have largely been limited to passive market-value-weighted index exposures and actively managed bond funds. Both have drawbacks. Passive market-value indexes have low fees and deliver a pure beta by buying everything the market offers, but they place investors' money in each bond in proportion to the size of the issue. In other words, the more a company borrows, the greater its weight in a bond index fund. Active managers attempt to generate alpha on top of the returns to systematic risk that the broad market index funds offer. But their fees are higher and their excess returns are often skimpy (or negative).
A third route has recently piqued investors' interest. Smart-beta bond strategies combine the transparent, rules-based approach of conventional indexes with the active managers' potential for better investment outcomes. These new approaches provide relatively low-cost access to the bond markets, and, as this paper will explain, they do so more efficiently than traditional passive funds. In addition, rather than relying on portfolio managers' insights in shifting market conditions, smart-beta strategies provide systematic access to sources of value-added returns. Moving away from market-value-weighted allocations creates a less risky portfolio with an opportunity for superior long-term performance—a more efficient beta.
Bonds, in concept, are extremely simple instruments. From the investor's perspective, the purest form of fixed-income instrument—a discount bond—represents a legal claim on a single cash flow at a single prespecified point in time. More complex obligations can generally be modeled as different series of projected cash flows. But when these cash flows are actually valued and traded in the financial markets, they come replete with various risk exposures: interest rate, default, prepayment, liquidity and more. In this paper, we will focus on the core risk exposures (and core drivers of beta), credit and duration, in the corporate bond market.
Making Room For Smart Beta
What do smart-beta indexes bring to the table that the market currently does not offer? Is there a need for smart-beta strategies in the bond markets? We argue that smart-beta strategies tend to deliver value-added returns despite an embedded preference for bonds from lower-risk issuers, potentially providing better value and more efficient market-beta exposure than conventional approaches to bond investing.
So where do smart-beta strategies fit in relation to passive investing and active portfolio management in corporate bond portfolios?
Traditional bond indexes buy bonds according to their market valuation; that is, the size of the issue multiplied by its price. They therefore favor bonds from the companies or countries with the greatest amount of debt outstanding, and they favor bonds with higher prices relative to their par value. Furthermore, as companies or countries issue more debt (raising their leverage and frequently increasing the riskiness of their bonds in the process), the market index responds by increasing its exposure to that issuer's bonds; likewise, as bonds move up in price, the market index automatically increases its exposure to these more expensive bonds.1 (Conversely, market indexes systematically reduce their exposure to bonds as they drop in price and offer a higher yield.) There are, then, two crucial drawbacks to the market index: It offers beta exposure with an emphasis on riskier issuers; and it favors more expensive bonds over cheaper bonds whose underlying creditworthiness may be stronger than the prevailing credit spread suggests [Arnott, Hsu, Li and Shepherd, 2010].
On first hearing the idea, placing investment dollars according to the value of debt outstanding seems questionable. After all, bond investors are lenders. Who else makes loans this way? Why would we think that the attractiveness of a borrower who is already encumbered with debtshould increase when they come back to the market asking for additional loans? If anything, our common sense and gut instinct tell us the opposite; all other things being equal, we should find borrowers less attractive as they take out more loans. And this first impression is largely correct except in one special case.