Fixed Income Factor-based Investing - Part II - The New Versus Tradition Approach

 

Fixed income factor investing has changed how bond managers look at and measure risk. However, it is not a replacement to traditional approaches which have served as a core framework for classification. There is a place for both with factor investing providing a common framework that links fixed income with other asset classes.

Factor investing applied across asset classes allow for a unified framework for the discussion of risks. Whether equity, currency, bonds, or commodities, there are common factor approaches that can drive discussion, measurement, and assessment of risk. Value, quality, size, momentum, carry, and volatility as well as other factors are measurable everywhere, so there is no need to think of bonds as special relative to other asset classes. Of course, a bond is a different contract for cash flows; nevertheless, a traditional approach to bond investing offer ways to classify bonds which will improve risk factorization. 

The traditional framework broke fixed income into three parts, interest rate risks associated with duration, creditworthiness as measured as spread compensation for default risk, and liquidity-based measures for trading in an OTC dealer market. The credit analyst focuses on spread analysis after controlling for underlying Treasury benchmark risk. The traditional approach is tied to risk assessment relative to ratings and liquidity cost scoring measured by individual, common, and group classification: 

• Individual bond characteristics: size, age, time to maturity, coupon, carry, and premium
• Common characteristics: size of issuer sector, size of country, credit rating
• Group characteristics: Treasury, IG, HY, inflation-linked, subordination, zero coupon, currency, financial, supranational, Agency (government-related) 

The factor approach does not break this connection with ratings but focuses on enhancing the measurement of risk characteristics using the power of cross-sectional risk premium sorts. The power of cross-sectional analysis with more effective bond databases makes for effective risk sorting in a manner consistent with equity markets.